[Yoo Choon-sik] KDI’s warning against Fed-tied policy

The Korea Development Institute’s revised economic forecasts and comments, released last week, contained sources of confusion for investors regarding the central bank’s monetary policy direction for the rest of the year because it warned against tying the country’s interest rate policy too closely to that in advanced economies.

In its biannual event, South Korea’s most influential research institute upgraded this year’s economic growth forecast to 2.6 percent from 2.2 percent predicted in November last year, while maintaining the inflation projection at 2.6 percent as seen at that time. But it lowered the projection for this year’s core inflation to 2.3 percent from 2.4 percent seen previously.

While the margin of increase in this year’s economic growth forecast is significant, the government-run think tank emphasized that the change was mostly attributable to robust exports of key products and added domestic demand, such as private consumption and investment by companies, would largely be weak.

In fact, the KDI maintained its forecast for this year’s private consumption growth while downgrading the projection for capital investment and construction spending, citing high interest rates as a key factor. In its concluding remarks, the KDI recommended gradual normalization of the country’s monetary policy away from a tightening stance even before the US Federal Reserve begins easing its own policy.

The KDI said the country’s monetary policy authority has little reason to respond sensitively to the fluctuations in the prices of farm products, petroleum products and others that are volatile by nature. This means the Bank of Korea needs to pay more attention to core inflation, for which the KDI lowered its forecast for this year in its latest projection.

These comments, which put the Bank of Korea under pressure to consider cutting interest rates soon despite recent surges in fruit and domestic oil product prices, came just days before the central bank is due to review its monetary policy later this week. The comments also came days after the Bank of Korea’s chief suggested the monetary policy board members may need to reconsider policy direction at the May 23 meeting.

Bank of Korea Governor Rhee Chang-yong told reporters early this month that the monetary policy board may need to change its policy projection made in April, citing a delayed timing of the likely US interest rate cut, South Korea’s stronger-than-expected economic growth, elevated oil prices and unstable foreign exchange rates. He made the remarks while visiting Tbilisi, Georgia to attend the Asian Development Bank annual meetings.

While Governor Rhee did not specifically say the monetary policy board will change its view that it will likely begin cutting interest rates later this year, his comments were widely interpreted as indicating that the timing for an interest-rate cut could be pushed beyond this year. But this abrupt change in stance can cause unnecessary confusion in the financial markets, doing more harm than good to the economy as a whole.

According to the KDI’s forecasts for this and next year, construction spending is seen shrinking for both years, bringing the three-year average since the inauguration of President Yoon Suk Yeol to a decline of 0.4 percent, compared with an average of 3.6 percent growth during the five years before the 2020 pandemic. Private consumption and capital investment are also widely seen remaining depressed, indicating that gross domestic product growth is almost solely driven by the surge in exports from an extremely weak performance in 2023.

Even if this year’s GDP growth exceeds earlier expectations, next year’s growth will likely lose momentum quickly unless domestic demand escapes the slump soon. The KDI’s forecasts indicate the average GDP growth for the 2023-2025 period would be only 2.0 percent, still below the country’s potential growth rate, not to mention the five-year average of 2.8 percent before the COVID-19 pandemic.

In the past, exports used to be an important driver of economic growth because export companies increased investment and hired more workers within the country when overseas sales rose. However, the situation has changed as export companies no longer bring in gains from overseas sales because they have to increase investment abroad, either due to strict regulations imposed by the United States or simply to save various costs.

Regarding monetary policy, there is no denying that the central bank’s top mission is to keep inflation stable while paying attention to financial stability. But inflation in South Korea has come down in a more disciplined manner than in many other countries and is on a solid path downward, while no longer posing a serious threat to the overall economy.

It is time for policy authorities to worry more about the negative effects of an excessive cooling in domestic demand for an unnecessarily long period than about inflation threatening the economy. I hope the monetary policy board will remain as predictable as it used to be since it made a bold decision to begin raising interest rates in the middle of 2021 before the central banks of advanced economies did.

Yoo Choon-sik

Yoo Choon-sik worked as the chief Korea economics correspondent at Reuters and is now a business and media strategy consultant. The views expressed here are the writer’s own. -- Ed.

By Korea Herald(khnews@heraldcorp.com)