The Bank of Korea's Monetary Policy Committee has paused the rate cut that began last October by keeping the base rate at 3.0% per annum. Although the possibility of weak domestic demand has increased due to political uncertainties like martial law and impeachment, it seems the decision to maintain the rate was made in consideration of the financial instability that arose as the won-dollar exchange rate surpassed 1,460 won.
The Bank of Korea's Monetary Policy Committee (hereafter referred to as the committee) held a regular meeting on the 16th and decided to keep the base rate at 3.0% per annum. Since raising the base rate from 0.5% to 3.5% from August 2021 to January 2023, the Bank has maintained the rate for 1 year and 7 months. Then, in October of last year, the rate was lowered to 3.25%, and in November, it was further reduced to 3.0%.
In the committee's monetary policy direction resolution, it noted that "the inflation rate is stabilizing and household debt is on a declining trend, but unexpected political risks have increased, raising downside risks to growth and increasing exchange rate volatility." It concluded that "given the increased uncertainty in economic outlook and foreign exchange markets due to changes in domestic political circumstances and major countries' economic policies, it is deemed appropriate to maintain the current base rate while assessing domestic and external conditions further."
Ahead of the committee meeting, the market was torn between expectations of a rate freeze and a rate cut. A survey conducted by the Korea Financial Investment Association from the 3rd to the 8th of this month, targeting 100 bond holders and operators, revealed that 60% of respondents anticipated a rate freeze, while 40% expected a reduction of 0.25 percentage points. Although more opinions favored a freeze, there was also significant sentiment for a rate cut, leaving possibilities open in either direction.
The recent surge in the high exchange rate has dampened concerns about economic slowdown. The exchange rate fell to around 1,450 won as expectations surfaced that the new U.S. government's anticipated universal tariff (imposing tariffs of up to 20% on U.S. imports) might be restricted to select key items. However, on the 10th (local time), the U.S. non-farm payrolls exceeded market expectations (155,000 jobs) by more than 100,000, leading to a renewed perception of robustness in the U.S. economy and causing the exchange rate to spike back to the 1,470 won range.
The possible delay in the pace of U.S. interest rate cuts appears to have also had an impact. If the large-scale tariffs and tax cuts previously announced by then President-elect Donald Trump are implemented, the prices of U.S. imports and consumer goods may rise. This could slow the rate cuts by the Federal Reserve (Fed). In such a case, the Bank of Korea would need to maintain the current interest rate gap of 1.5 percentage points (upper limit: 3.0% for Korea and 4.5% for the U.S.), making it difficult to lower rates.
However, the factors that initially restrained the rate freeze have yet to be resolved, which increases the possibility of a future rate cut. Firstly, the ongoing political uncertainties, including martial law and the impeachment situation, have intensified concerns about weakened consumer sentiment and the potential for domestic demand to slow down. According to the Korean Statistical Information Service (KOSIS), retail sales index from January to November of last year decreased by 2.1% compared to the previous year, marking the largest drop since the same period in 2003 when it fell by 3.1%.
The slowdown in the growth of exports, which had supported the South Korean economy, is also a factor raising the need for rate cuts. According to the Korea Development Institute (KDI), while the daily average export figures in December rose significantly in the ICT sector (27.9%), other items (-3.6%) declined due to weak global demand. The Bank of Korea has projected the economic growth rate to be 1.9% for this year and 1.8% for next year, which falls below the potential growth rate of 2.0%, the foundational capacity of the economy.
Jo Yong-gu, a researcher at Shin Young Securities, said, "It is fundamentally expected that the Bank of Korea will implement a cut once in the first and second quarters, lowering the base rate to 2.5% by the end of the year," adding that "the timing of the second cut will be aligned with the supplementary budget preparation or just before or after its execution to mitigate the crowding out effect (the phenomenon where government expenditures lead to a decrease in similar or the same scale of private investment or consumption)."