BOK likely to hold key rate steady as inflation eases

The Bank of Korea is expected to keep its key interest rate unchanged this week as recent economic indicators show signs of waning inflation.

If the central bank maintains the policy rate at 3.5 percent at its rate-setting meeting scheduled to take place on Thursday, it would be its fourth consecutive freeze since February.

Signs of inflation cooling have created room for the BOK to keep the rate at the same level.

Korea’s consumer prices, a key gauge of inflation, rose by 2.7 percent in June from a year earlier, according to Statistics Korea. It was the first time since September 2021 that the figure was below 3 percent.

"Consumer price growth came down to the 2 percent range as projected due to the base effect," Kim Woong, deputy governor of the BOK said last Tuesday. "The slowdown was led by the deceleration in rents and smaller increase in service charges."

Consumer inflation has been on a steady decline this year, falling from the 5.2 percent in January to 3.3 percent in May.

Core inflation, which excludes food and energy prices because they are more volatile, is easing off as well. Last month’s core inflation was 4.1 percent, marking a 0.4 percentage point drop from May.

Yet, the decline is slower than that of headline inflation, which was driven by the base effect from the spike in oil prices last year. Core inflation fell 0.9 percentage point from 5 percent in January.

The BOK still has inflation concerns. The central bank is not likely to relax its relatively tight monetary policy, as inflationary pressures on food and energy still exist. The consumer price growth target rate set by the BOK stands at 2 percent.

The market expects the central bank to keep the 3.5 percent base rate while maintaining a hawkish stance, leaving room for further rate raises in the near future if inflationary pressures need further mitigation.

"If headline inflation continues to go down this year, the pressure on the BOK to control inflation will lessen," Ahn Ye-ha at Kiwoom Securities said. "The central bank is unlikely to go for a rate increase unless consumer inflation rebounds."

The recent crisis involving the Korean Federation of Community Credit Cooperatives, the nation's primary mutual financial institution, also makes it harder for the BOK to lift the key rate.

Though it is unlikely the situation will develop into a bank run crisis like that of Silicon Valley Bank in the US, raising the base rate could escalate volatility.

The US Federal Reserve's expected rate hike is another concern for the BOK.

The current Korea-US policy rate gap stands at 1.75 percentage points. If the Fed lifts the rate by a quarter percentage point to a range of 5 to 5.25 percent at the end of this month, as suggested by the market, the rate gap will widen to 2 percentage points.

Furthermore, market data suggests the Fed will deliver two rate hikes this year. That means the gap could widen to 2.25 percentage points this year if the BOK continues to freeze the rate.

A widening rate gap increases the incentive for foreign investors to move their money out of Korea in pursuit of higher returns.

But the market continues to expect the BOK to keep the current base rate as the exchange rate has remained stable.

“The BOK responds to currency volatility rather than the rate gap itself. The currency volatility has been low,” analyst Lim Jae-kyun from KB Securities said. “As the Fed has neared the end of its tightening cycle, a further rate raise is not likely to heighten the currency volatility.”

As Lim said, the won-dollar exchange rate had remained stable in the late 1,200 won to early 1,300 won range in the past few months, compared to the spike into the late 1,400 won range end of last year.

The widened rate differentials may not directly lead to an outflow of foreign capital. Despite the widened gap in past months, foreign investors have purchased record amounts of Korean stocks and bonds in May.

“Korea is not yet at a point where it has to raise the base rate out of concern that the rate gap with major nations will cause a capital outflow,” Ahn said.