Korea’s monetary policy put to test

South Korea’s consumer inflation rate fell below that of the average of the G7 economies last year for the first time in eight years, according to data by the Organization for Economic Cooperation and Development.

Korea’s annual inflation rate stood at 1.3 percent last year, compared to the G7 average of 1.6 percent. The G7 economies are the U.S., Japan, the U.K., France, Germany, Italy and Canada.

Korea’s inflation rate also fell below the G7 average in 1999 and 2006.

Falling global oil prices and weak consumption caused by last year’s Sewol ship sinking have led consumer prices to decline, raising concerns that Korea could face deflation. Korea cut its inflation forecast from 2.4 percent to 1.9 percent this year.

“Lower oil prices will fail to give a significant boost to global growth in the next two years as the gradual slowdown in China and headwinds from Japan and the euro area hold back economic activity,” said Moody’s Investors Service in its report.

With global central banks such as in Europe, Japan and Canada easing their monetary policies to combat low growth through currency depreciation, the Bank of Korea is facing a dilemma.

Additional rate cuts by the Korean central bank could fuel household debt, which has alarmingly ballooned following two rate cuts last year to support the government’s real estate stimulus.

Although BOK Gov. Lee Ju-yeol recently hinted that the central bank may hold the interest rate steady to keep household debt in check, Asia’s fourth-largest economy is about to face a currency war, as lowered interest rates and unorthodox policies by global central banks will weaken their currencies.

The eurozone, which has cut its benchmark interest rate to 0.05 percent, has resorted to bond-purchasing in the face of low growth and deflation. Europe saw its consumer prices drop by 0.6 percent last month, further deepening deflation concerns.

Deflation poses a greater downside risk to the economy than inflation, as decreasing prices could push consumers to purchase goods in the later period. Monetary tools to combat deflation include slashing rates and injecting capital into the market. A weak currency stemming from easy money policies will spur exports.

The U.S. remains one of the few economies with a rosy outlook as it picks up recovery momentum this year. Analysts expect the U.S. to start raising its interest rate later this year on the back of increasing job creation.

Korea, which depends mostly on exports, is likely to freeze its rate this month.

By Park Hyong-ki (hkp@heraldcorp.com)