Monetary Policy Board Takes a Second "Big Step" and Raises the Base Interest Rate from 2.50% to 3.00%

Bank of Korea Governor Rhee Chang-yong presides over a meeting of the Monetary Policy Board at the Bank of Korea in Jung-gu, Seoul on the morning of October 12. Courtesy of the Bank of Korea

The Bank of Korea Monetary Policy Board took another “big step” raising the base interest rate by 0.5% from the current 2.50% to 3.0%.

On the morning of October 12, the Monetary Policy Board held a meeting to discuss the direction of the nation’s monetary policy at the Bank of Korea in Jung-gu, Seoul and decided to raise the base rate 0.5%. This is the first time in a decade since October 2012 that the base rate has reached 3%. The Monetary Policy Board raised the base interest rate for the fifth consecutive time following their decisions in April, May, July and August, which was also a first.

The biggest reason for the higher base rate is inflation, which refuses to decline from the current high. Governor Rhee Chang-yong has constantly said, “Although it may be painful, when the inflation is at the 5% level, it is better to control the inflation by raising the interest rate.” In September, the consumer price index (108.93) in South Korea rose 5.6% from the same month last year. Inflation has slowed down for two consecutive months following August (5.7%), but it remains over 5.5%. The central bank expects the inflation rate to remain over 5% until the first quarter next year.

The wider gap with the U.S. base interest rate and the ensuing risk of a higher foreign exchange rate and consumer prices also support the latest interest rate hike.

At present, the gap between the base rates of South Korea (2.50%) and the U.S. (3.00-3.25%) can be as large as 0.75%. After the Board’s decision this day, the gap has narrowed back down to 0.25%. However, the U.S. Federal Reserve is likely to raise the interest rate as much as 1.25% in November and December, so the gap is expected to widen again.

If the interest rate in the U.S. is higher, foreign capital seeking higher returns will leave the country, forcing the value of the Korean won to fall. So it will be hard for South Korea to just stand and watch. Besides, if the exchange rate continues to soar, it will lead to higher prices for imported goods, further pushing the inflation rate up, when experts are expecting inflation to peak in October.

Ahn Ye-ha, a researcher at Kiwoom Securities said, “The Fed raised the interest rate at a fast rate in September and has announced that it would do so again in November,” and added, “The Bank of Korea will not let the gap with the U.S. continue to grow,” suggesting the possibility of another big step.

The market’s attention is on whether the Monetary Policy Board will be open to the possibility of another big step in November. Lim Jae-kyun, an analyst at KB Securities said, “Since more than 70% of household loans are variable-rate loans, a higher base rate will put pressure on the interest, but since the Bank of Korea’s priority right now is to stabilize consumer prices, I believe they will be open to the possibility of another big step in November.”