Since the end of last year, the Bank of Korea's interest rate cut cycle has begun, and interest has focused on the 'neutral interest rate,' which can gauge the final interest rate level. Recently, discussions about the neutral interest rate have become active in the Monetary Policy Committee. This indicates that the role of the neutral interest rate as an indicator of monetary policy is being emphasized.
The neutral interest rate refers to a theoretical interest rate level that maintains the potential growth rate without overheating or stagnating the economy. If the benchmark interest rate is lower than the neutral interest rate, it stimulates inflation as the economy expands, and conversely, if it is higher, the risk of deflation (a drop in prices amid economic stagnation) increases.
◇ South Korea's neutral interest rate 1.8~3.3%... If adjusted upward, the number of interest rate cuts will decrease
According to the minutes of the 1st Monetary Policy Committee meeting in 2025 released by the Bank of Korea on 4th, some committee members have raised the need to re-examine the neutral interest rate level. The neutral interest rate has been trending down due to a slowdown in potential growth, but it is now estimated to have risen somewhat due to deepened financial imbalance and external factors.
One committee member noted, 'The neutral interest rate, considering financial stability and external factors, should be examined for theoretical grounds and robustness of estimation,' adding that 'additional research is needed on the impact of the domestic neutral interest rate on exports and imports through exchange rates.' Another committee member said, 'We need to further examine whether the incomplete nature of exchange rate fluctuations or their effects on domestic financial stability and trade routes require more theoretical discussions.'
The importance of the neutral interest rate lies in its role as a benchmark for presenting an appropriate interest rate level for rate cuts. In 1993, U.S. economist John Taylor proposed the 'Taylor Rule,' which calculates the appropriate benchmark interest rate based on the real neutral interest rate, inflation rate, and inflation target. Although several variations have emerged, the framework for deriving the benchmark interest rate based on the neutral interest rate has been maintained.
In May of last year, the Bank of Korea estimated the real neutral interest rate for our country in the first quarter of last year to be between -0.2% and 1.3%, while the nominal neutral interest rate reflecting the inflation target (2%) was assessed at 1.8% to 3.3%. The neutral interest rate, which considers financial imbalances and external factors, was found to be higher than that which only considers growth and prices. Considering that the current benchmark interest rate in Korea is 3.0%, this means that interest rates could potentially be reduced by up to 1.2 percentage points without causing inflation.
However, if the neutral interest rate rises, the situation changes. Shin Young Securities research analyst Jo Yong-gu said, 'Bank of Korea Governor Lee Chang-yong recently stated in an interview with foreign media that the benchmark interest rate is near the upper bound of the neutral interest rate considering financial stability, so if the neutral interest rate rises, it will affect the number of rate cuts.' Specifically, he explained, 'Considering the current exchange rate, household debt, and real estate prices, it is likely to be a level where we could cut rates one less time (0.25 percentage points).'
◇ Some argue that it is difficult to assess the impact of monetary policy… Bank of Korea 'will utilize various reference indicators'
There are claims that even if the neutral interest rate changes, it will be difficult to impact monetary policy in the short term. This is because the determination of the benchmark interest rate reflects various indicators such as neutral interest rates, potential growth rates, and price levels, and the methods for estimating each indicator vary. When inserting various calculated indicators into different formulations for optimal benchmark interest rates, dozens of appropriate interest rate levels can emerge.
The high uncertainty in estimating the neutral interest rate supports this perspective. The neutral interest rate is derived through various variables such as exchange rates, current accounts, capital mobility, and global factors, and changes in these variables can significantly alter the estimates. A Bank of Korea official stated, 'Internally, we re-examine the neutral interest rate each time a monetary policy direction meeting is held, and there are fluctuations each time,' adding, 'Fundamentally, there is a high degree of uncertainty.'
As the possibility of a domestic economic slowdown increases, some argue that more attention should be paid to the neutral interest rate considering only growth and prices rather than that reflecting financial imbalances. This means that the emphasis should be placed on the lower bound rather than the upper bound of the neutral interest rate estimation range. NH Investment & Securities bond strategy team leader Kang Seung-won stated, 'During the period when the U.S. was raising interest rates, the risk of financial instability due to the widening interest rate gap between South Korea and the U.S. was significant, but after the Federal Reserve's shift in monetary policy, such concerns have diminished,' adding, 'Currently, we should focus on the neutral interest rate reflecting only growth and prices.'
The Bank of Korea plans to decide on monetary policy considering various neutral interest rates along with trends in prices and growth, household debt ratios, and domestic and foreign interest rate differentials. A Bank of Korea official stated, 'We will continue to utilize various neutral interest rates as reference indicators in managing monetary policy,' adding, 'Given the uncertainty in estimating the neutral interest rate, it is also essential to consider various related indicators such as financial conditions, prices, and growth trends.'