The Bank of Korea froze the benchmark interest rate at 3.00% during its first monetary policy direction meeting of the year. This halted the rate cut streak that had been ongoing since October of last year. Although conditions for a rate cut were created due to growing concerns about an economic slowdown, the sharp rise in the won-dollar exchange rate caused by domestic and foreign political uncertainties appears to have hindered a reduction in rates.
The market expects a rate cut to be implemented at the upcoming Monetary Policy Committee meeting next month. One of the six commissioners, excluding the governor (Commissioner Shin Seong-hwan), expressed a minority opinion advocating for a rate cut, and all six commissioners indicated that they should keep the possibility of a reduction open in the forward guidance, which aggregates their three-month interest rate outlook.
◇ Freeze the benchmark interest rate at 3.00%… Pausing rate cuts
The Bank of Korea's Monetary Policy Committee decided to freeze the benchmark interest rate at 3.00% during its regular meeting held on the 16th. The Bank kept rates steady for 1 year and 7 months after raising the benchmark rate from 0.5% to 3.5% from August 2021 to January 2023. Following a cut to 3.25% in October last year and further to 3.0% in November, the committee chose to pause at this meeting.
Ahead of this day's Monetary Policy Committee meeting, there was a tight contention between expectations for a freeze and a cut in the benchmark interest rate. A survey conducted by the Korea Financial Investment Association from the 3rd to the 8th among 100 bond holders and operators showed that 60% of respondents expected a rate freeze, while 40% anticipated a 0.25 percentage point (p) reduction. Although there were more proponents of a freeze, the significant expectation of a cut kept possibilities open for both outcomes.
Reflecting this trend, the decision of this Monetary Policy Committee was not unanimous. Commissioner Shin Seong-hwan, a notable 'dove' on the committee, argued that it would be appropriate to cut the benchmark rate by 25 basis points (bp; 1 bp = 0.01 percentage point), citing that the direction of a rate cut has already been reflected in the foreign exchange market and that demand pressures are likely to diminish due to economic slowdown.
The difficulty of this decision stemmed from the simultaneous occurrence of consumption slowdown and soaring exchange rates. Governor Lee Chang-yong noted, "Although it would be natural to lower rates based on the economic situation, we considered the external balance focused on exchange rates this time," adding that, "The exchange rate has risen unnecessarily compared to normal circumstances, so we need to be mindful of its impact on prices and domestic demand."
However, Governor Lee left the door open for further cuts, conveying that the reduction trend has not ended. He said, "There is a possibility that the fourth-quarter growth rate (compared to the previous quarter) could fall below 0.2%," noting an increased necessity for rate cuts amid growing downside risks to growth. The Bank previously forecasted that the fourth-quarter growth rate could drop from 0.5% to 0.4% and the annual growth rate from 2.2% to 2.1%, suggesting that the actual economic impact may be greater, leading to a lower growth rate.
The 'conditional forward guidance,' which aggregates the benchmark rate outlook among the six Monetary Policy Committee members excluding the governor, aligned with this sentiment. All committee members expressed that they should keep the possibility of a rate cut open in three months, supporting the notion of a rate decrease. The number of committee members who believed a cut could be feasible within three months increased from 4 (August of last year) to 3 (November) to 6 (January of this year).
◇ Maintaining a 'rate cut cycle' while adjusting pace… Expectation for 2.25% within the year
The Bank of Korea expressed a strong intention to maintain the overall trend of rate cuts while holding the benchmark rate steady, leading the market to evaluate this decision as a 'one-point' freeze. In light of all six Monetary Policy Committee members agreeing to additional rate cuts within the next three months in the forward guidance, the likelihood of a benchmark rate cut next month is significantly anticipated.
Shin Yong-gu of Shinyoung Securities noted, "Both in the forward guidance and in expressions such as 'the cut cycle will continue for a while,' many signals for a cut next month have been provided."
However, questions were raised as to whether the decision to freeze rates in light of high exchange rates would be effective. Baek Yoon-min of Kyobo Securities stated, "The current upward pressure on exchange rates was caused by the strength of the dollar, and I'm not sure how much the decision to freeze will stabilize the currency given that the Bank of Korea has effectively recognized a rate cut. Instead, it might have been better to lower rates and monitor the situation considering political risks or exchange rates."
As expectations for a rate cut gained traction, government bond yields fell across the board. On this day in the Seoul bond market, the three-year government bond yield fell by 4.9 bp (1 bp = 0.01 percentage point) to 2.626%. The yields for five-year and ten-year bonds also closed at 2.723% and 2.802%, down by 5.1 bp and 5.8 bp, respectively. The won-dollar exchange rate, which had dropped to 1449.8 won, rebounded in the afternoon and finished trading at 1456.70 won.
Experts predict that considering the revealing policy outlines of the U.S. government under Trump's second term and the potential for the Federal Reserve to adjust its rate cut pace, the Bank of Korea will also regulate its rate cutting speed. There are prevailing expectations that 2 to 3 cuts will occur this year, reducing rates to 2.25% by the end of the year.
Ryu Jin of SK Securities said, "From next month onwards, I think there will be decisions made on monetary policy aligned with the Federal Reserve's rate cuts," and added, "Given that the governor mentioned the 3.00% rate is nearly at the upper limit of a neutral rate considering financial stability, it seems unlikely they will rush to cut rates."
Research Institute Jo stated, "The exchange rate in the 1500 won range and the 2 percentage point difference in interest rates between Korea and the U.S. will be burdensome," predicting that "if the pace of rate cuts is delayed, the rate could drop to 2.5% by July, and subsequently, if the economy worsens or aligns with the Fed's rate cuts, the rate could go down to 2.25% by the end of the year."