The country’s central bank is facing a deepening dilemma on whether to cut its key interest rate, which has remained at a record low of 2 percent since October.
In recent months, the Bank of Korea has continued to send negative signals, cautioning that any further rate cut would result in increased household debt and capital outflow. But the BOK is under growing pressure from government officials and independent economists that it should no longer hesitate to reduce the rate to help spur the economy.
A recent string of data seems to strengthen the case for slashing the rate.
Korea’s industrial production dropped 1.7 percent from a month earlier in January. In particular, the output in the mining and manufacturing sector fell 3.7 percent, the sharpest monthly contraction in more than six years.
Exports and imports shrank 3.4 percent and 19.6 percent, respectively, in February from a year earlier.
Consumer prices grew a mere 0.5 percent on-year in February. The inflation rate hovered below 1 percent for three consecutive months.
These figures raise concerns that it may be difficult to achieve the government’s growth target of 3.8 percent for this year and that Korea’s economy is being drawn into a deflationary spiral.
From a more positive viewpoint, however, the growth goal may still be reachable, given that the effects of last year’s interest rate cut and falling oil prices are expected to start making an impact more tangibly in the second quarter. There is increasing likelihood that the more realistic target of 3.4 percent set by the central bank will be achieved.
Speaking in a session of the parliamentary finance committee last month, BOK Gov. Lee Ju-yeol downplayed concerns that Korea’s economy may be trapped in deflation. He noted the country’s inflation rate would hover around 2 percent when excluding the effect of sliding oil prices. In fact, it is not wrong to say the low inflation results partially from supply-side factors.
The main concern that holds back the BOK from further cutting the rate is that the measure would fuel an increase in the country’s already bloated household debt, which exceeds 1,100 trillion won ($991 billion). There are also concerns that a rate cut would heighten the tide of capital outflow, which may be prompted by a possible U.S. move to raise interest rates. With the U.S. jobless rate dropping to the lowest level since 2008, speculation is increasing that the Federal Reserve will raise rates for the first time since 2006 by September.
The Korean central bank’s Monetary Policy Committee, however, may find it difficult to stick to its cautious stance at its monthly meeting Thursday, as a wave of monetary easing measures has swept through major economies, including Japan, China and the European Union. As the euro slid, Korea’s exports to EU member states decreased 23 percent in January and 30.7 percent in February from a year earlier. Shipments of its goods to Japan and China have also shrunk in recent months.
In order to preempt this situation, the BOK should have cut its base rate more drastically last year, when concern over the U.S. rate increase was less immediate.
With either option carrying risks to the economy, the overall economic conditions at home and abroad seem to call for the central bank to be more positive toward a rate cut. Consumer prices have increased less than 2 percent in recent years, far below the BOK’s inflation target for 2013-2015 of 2.5-3.5 percent. This should be grounds for cutting the interest rate, not a reason to lower the inflation target.
