BOK freezes interest rate amid high inflation and high exchange rate

The Monetary Policy Committee of the Bank of Korea decided to keep the benchmark interest rate unchanged at 3.5 percent. The BOK’s decision comes as inflation remains high at 5 percent to address impending economic slowdown and household debts, indicating that Korea is on the verge of having to suspend rate hikes, notwithstanding the upcoming rate hikes by the Federal Reserve, which will further widen the rate gap between South Korea and the U.S. However, Bank of Korea Governor Rhee Chang-yong left room for rate hikes, asking for caution against a rushed assumption that there will be no more rake hikes.

The central bank put a brake on rate hikes that have continued for seven consecutive times since April 2022 to January 2023. It has been raising interest rates for a year and a half, from August 2022 to January 2023. Thus, the BOK’s downshift in the pace of rate hikes is a sign that a recession has become more likely. With total household debt having risen to 1,900 trillion won, households with an increased burden of interest payments are cutting back on consumption. With a total debt of more than 100 trillion won, debt-ridden self-employed and small business owners are also closing their businesses. The BOK’s lowering of growth forecast for 2023 from 1.7 percent to 1.6 percent was also based on its judgment that sluggish domestic demand and stagnant exports will not recover soon.

U.S. inflation is an economic variable leading the global interest rate hikes. Unlike Korea where the economy has slowed down, inflation does not seem to be slowing down in the U.S. owing to the rise in consumer spending and job growth. This is a so-called “no landing” scenario, which involves continuing economic growth and high inflation running in parallel. The possibility that the Federal Reserve will raise the key interest rate by 0.5 percentage points to 5.0-5.25 percent has also increased.

The widening rate gap between the U.S. and South Korea to 1.75 percentage points will trigger a massive exodus of foreign investors and prolong the reign of the “king dollar,” leading to a rise in the won-dollar exchange rate. Higher exchange rates will drive up energy import prices, which will build up more pressure on inflation, including gas and power bills. A freeze on interest rates, which was intended to counter weak domestic demand, will ultimately put more pressure on the domestic economy.

The International Monetary Fund has warned that central banks in Asia should “tread carefully by reaffirming their commitment to price stability.” In the 1970s when oil demand rose rapidly, the Fed repeated the freeze-thaw cycles of rate hikes and eventually failed to keep up with inflation. The Bank of Korea should learn from history and respond flexibly and promptly to economic volatility at home and abroad so as not to fall into the “stop and go” trap.