High interest rates could pose a greater threat than high inflation: KDI

[Photo by MK DB]

The Bank of Korea has maintained its benchmark interest rate at 3.5 percent for a year and five months, weighing on people‘s livelihoods, domestic demand, and investment in the country. But a recent analysis suggested that high interest rates could pose a greater threat than high inflation, raising the need for the government to implement a more preemptive monetary policy as the Korean economy shows signs of recovery and prices move past their peak.

The Korea Development Institute (KDI) said in a report on Thursday that “the recovery in the country’s exports is being reflected in a staggered manner and is acting as a positive factor for domestic demand” but that “the negative impact from high interest rates the government has maintained since the second half of 2023 exceeds the positive ripple effects of the export recovery.”

When interest rates remain high, companies have difficulty raising fundd and investment decreases. Households also tend to close their wallets and save more, curtailing consumption.

KDI’s analysis of the relationship between policy rates and consumption/investment from the first quarter of 2004 to the same period in 2024 shows that a one percentage point increase in interest rates reduces private consumption by up to 0.7 percentage points after three quarters, with the ripple effect lasting up to nine quarters after the increase. Capital investment will also drop up to 2.9 percentage points after three quarters, with the impact lasting up to eight quarters, indicating a greater shock.

“There is a time lag before the effects of monetary policy are transmitted to domestic demand,” KDI research fellow Kim Mee-roo said. “Even if BOK cuts interest rates in the second half of 2024, its (positive) impact on domestic demand will only be visible from 2025 onwards.”

For its part, Statistics Korea announced on the same day that consumer prices in April 2024 rose by 2.9 percent compared to the same period a year ago, the first time in three months that the rate has fallen below 3 percent.

The Organization for Economic Cooperation and Development (OECD) also raised its forecast for Korea‘s gross domestic product (GDP) growth for 2024 to 2.6 percent, up from the previous 2.2 percent. The forecast is based on the premise that Korea’s domestic demand, which has been sluggish thanks to high interest rates and inflation, will pick up with the expected interest rate cuts in the latter half of the year.