[SERI focus] Factors in the BOK’s decision to raise rates

Many economists anticipate that the Bank of Korea will continue to pursue a tighter monetary policy, after it hiked the call rate by 25 basis points to 4.75 percent last month.
To determine the likelihood of the BOK raising rates again, two previous time periods were examined in which at least two rate hikes were made: February 2000 to January 2001 and October 2005 to the present. In the first period, the BOK raised the target rate by a total of 50 basis points from 4.75 percent to 5.25 percent. In the second, commencing in October 2005, interest rates were hiked six times to the current 4.75 percent. Three main factors were identified that influenced monetary policy in one of the two time periods: consumer prices, liquidity and interest rate differentials between Korea and major economic powers.
Inflationary concerns seemed to play a key role in the BOK’s decision to hike rates in 2000. Consumer prices rose 2.3 percent in 2000. In particular, the specter of inflation became more vivid in the third quarter of 2000 with prices rising 3.0 percent year-on-year. In contrast, prices showed a downward stabilizing trend in 2005 when the BOK decided to begin hiking rates. While prices rose 2.8 percent in 2005, they had clearly decelerated to 2.4 percent in the second half. In this sense, consumer price levels seemed to play a more decisive role in the BOK’s decision to hike interest rates in 2000 than in 2005.
Liquidity levels seemed to be a key concern over both time periods. Although not technically part of its mandate, the BOK regularly makes an issue of liquidity as excess liquidity can cause asset inflation, which will ultimately lead to higher prices. Liquidity expanded at 12 percent in 2000 and 14 percent in 2001 on the back of aggressive interest rate cuts in major economies. Low interest rates fed liquidity, which in turn, encouraged banks to aggressively lend money. This led to a noticeable increase in house prices.
Finally, the interest rate differential between Korean and other major economies was another key consideration. In 2000, diverging interest rates played only a minor role. Rate differences between Korea and other major countries such as the United States have noticeably narrowed since 2005, while the interest rate differential has widened with key trading partners.
We conclude that BOK will further hike rates at least once in the second half of 2007. In general, countries with higher growth rates should have higher interest rates. Although Korea has achieved faster economic growth than the United States over the past few years, its benchmark rates are still currently 50 basis points lower.
This indicates there is, theoretically, room for further hikes. The widening interest rate gap with Japan, however, will serve as a key factor pressuring future hikes. If the rate gap continues to widen between the two countries, capital inflows will continue into Korea, putting pressure on the won to appreciate, and perhaps adversely affect exports and economic growth.

The writer is a research fellow at the Macroeconomic Research Department, Samsung Economic Research Institute. Inquiries on this article should be addressed to hc.

[jeon@samsung.com.]