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Key Interest Rate Frozen at 3.25% for 3rd Month
The government are stuck in dilemma between inflation and economic growth
Key Interest Rate Frozen at 3.25% for 3rd Month
  • By matthew
  • October 5, 2011, 14:17
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On June 30, the Minister of Strategy and Finance Park Jae-wan made public the government’s economic policy direction for the second half of 2011. He clarified that the incumbent administration would further focus its policy efforts on price stabilization, citing the GDP growth target adjusted downward by 0.5 percentage points as evidence of its commitment.

Nevertheless, in June and July, consumer prices rose 4.4% and 4.7% from a year earlier, respectively. In August, the figure swelled to 5.3%, setting a new three year high; the monthly inflation rate was 5.6% in August 2008. The government is closely monitoring the situation, with agricultural product prices soaring along with those of processed foods and dining out.

At present, its economic growth and inflation target rates are set at 4.5% and 4.0% each. However, such targets will not be easy to achieve. As such, the Office of the President is fumbling for a magic wand that will keep inflation at bay while doing no harm to the national economy.

“Though some are claiming that it is the price index, not the growth rate, which we should concentrate on, the two are quite complicated and very closely intertwined,” said a high-ranking official at the Office of the President, adding, “As of now, prior to the upcoming Monetary Policy Committee (MPC) meeting, nothing can be nailed down concerning the direction of the key interest rate.” He went on, “We are exploring every avenue with utmost care because it is very tricky to strike a perfect balance between the suppression of inflation and the maintenance of a certain level of economic growth so as not to trigger a recession.”

One of the most sure-fire ways to curb inflation is to raise the base rate. However, doing so could exacerbate the household debt problem, which is emerging as a big threat, and slow down economic growth. This is why the government is finding itself in a catch 22 situation.

With the circumstances as they are, the Office of the President stayed quiet on what would be the optimal level of interest rate, while keeping a close eye on the MPC meeting of September 8. On that day, the MPC kept the rate steady at 3.25% for the third consecutive month. The decision was mainly because of the downside risk of the national economy perking up its head in the middle of global uncertainties.

“We could not rule out the possibility of the annual inflation rate surpassing the target 4%,” remarked The Bank of Korea governor Kim Joong-soo after the meeting. He continued, “Given that the average inflation rate between January and August was approximately 4.5%, the goal is quite challenging.” As a matter of fact, the inflation rate during the eight months never dipped below the 4% mark. The governor explained that the rise in vegetable and gold prices, above anything else, made it miss the mark. The Bank of Korea had previously forecasted the inflation rate in August to be close to 5%.

During a press interview, he commented that the base rate freeze was somewhat inevitable due to various unfavorable factors, including recession among advanced economies. “With downside risks larger than in the past, a lot of policy changes are on the horizon, e.g., the US President’s announcement, the G7 finance ministers’ and central bank governors’ meeting and the FOMC meeting,” he added. He also told reporters that countries around the world would continue to struggle to cope with uncertainties and that Korea would have to watch the situation very carefully, and added that he was forced to delay a rise of the base rate even though he was feeling some responsibility as the head of the central bank amid the high inflation expectations.

He was negative about the possibility of a key rate increase, as long as the global market situation was not further aggravated. “The rate will be jacked up when the time is right, but it seems that we are not in that position yet,” he commented. Concerning a possible rate decrease, he gave an outright reply, “We have not given it a thought and this is no time to think about cutting the rate.”

He also suggested that the bank would not resort to a rate hike in order to resolve the problem of swelling household debt, stating the interest rate is a tool with a huge ripple effect that can influence everyone. “As far as those in certain income brackets are concerned, the problem is severe, and I myself am well aware of the gravity,” he said. He explained that it was in this very vein that The Bank of Korea has raised the interest rate five times since July 2010.

In regards to the MPC meeting result, industry experts are giving their own analyses. Daewoo Securities researcher Yoon Yeo-sam said, “It is not fair to say that The Bank of Korea will keep the rate where it is for the rest of the year in order to curb inflation since it has to do with household debt,” adding, “The base rate may rise at least once before the end of 2011, after policy details are settled and financial market instability subsides.”

Researcher Kim Eui-chan of Daishin Securities analyzed that The Bank of Korea may well find it difficult to elevate the rate with uncertainties still lingering in the United States and Europe. “The bank seems to be focusing more on volatility abroad than on inflation concerns at home, and on the assumption that things do not get worse than they are now, it has every reason to adjust the rate upward during the second half because it is not insignificant to control inflation.”

Woori Investment & Securities analyst Park Jong-yeon commented, “The decision to freeze the key rate this month is seen to be founded on unfavorable conditions overseas and the subsequent necessity to buttress the domestic economy.” He analyzed that the central bank put more weight on downside risks than inflationary pressure, with both of those hanging heavy.

Still, he disagreed with the first two researchers as to the possibility of the bank hiking the rate before 2012. “Unless the world economy rebounds or major nations tighten their purse strings altogether at the same time, Korea will not be motivated to increase the rate because the action, doing little toward price stabilization, could only shrink capital inflow and private consumption alike.”

In the meantime, worries regarding economic slowdown were more conspicuous than ever in the monetary policy directions released by the central bank on September 8. According to the announcement, emerging economies are showing some signs of picking up, whereas advanced nations are losing steam in terms of pace. Though the overall global economy is forecasted to remain on the track of mild recovery, risk factors such as recession in some major countries and the eurozone’s sovereign crisis are still loitering.

The Bank of Korea said that it will closely monitor risks across the board and ensure that the growth of the national economy remains solid, with its monetary policy contributing to prize stabilization. “The base effect from the previous year and the stabilization of the prices of agricultural products will chip away at inflation rate down the road,” said the central bank, adding, “Nonetheless, inflation expectations will stop the figure from falling as much as desired and the core inflation rate will not show a remarkable drop overnight, either.”