By Kim Jae-kyoung
BusinessFocus editor

Inflation has arrived here. Now it has become more rampant, stoking inflation expectations and alerting the central bank. The problem is there’s no effective policy option for the central bank to tame inflation.

It seems that the monetary transmission mechanism, the process by which interest rate changes affect inflation, has been impaired after the Bank of Korea (BOK) missed a number of chances to hike key rates ― seven-day repurchase agreement rates ― and lost confidence in the market.

In other words, a rate increase by the central bank has failed to make its way through the economy. In theory at the first stage, a change in policy rate set by the central bank will lead to a rise in market rates which will, in turn, affect savings and loan rates at banks.

The change will then affect the prices of many assets, including shares and houses. The exchange rate may also change to adapt to the new level of interest rates. Finally, all those changes in the markets will affect the spending patterns of consumers and firms, affecting aggregate demand.

However the key link between key rates and other interest rates at the first stage has been flawed. They are now moving in opposite directions. The central bank has raised key rates by 100 basis points to 3 percent from 2 percent in January 2010. During the same period yield on three-year state bonds decreased by 20 basis points to 3.76 percent Friday.

This bizarre trend happens when the central bank loses public confidence and its actions are preempted by the market. Good news for the BOK. It is not an isolated problem in Korea. In many advanced countries, including the United States, central banks are facing a policy dilemma with monetary policies becoming ineffective due to ample liquidity in global market.

BOK Governor Kim Choong-soo may claim that what’s happening is not the result of impaired monetary mechanism but the outcome of a massive inflow of foreign capital, including Chinese money.

It is a valid argument. Over the past months on expectations of a stronger won a huge amount of offshore money has flown into the local bond market, pulling down bond yields and distorting the transmission mechanism.

The central bank claims that this strange phenomenon will swing back to normal once the Fed shifts its stance to credit tightening, which analysts believe will drive global funds out of the country.

It is true that the current trend is caused in some part by external forces. However there is still one thing that Governor Kim and his colleagues must pay attention to. Market participants do not listen as carefully to the central bank as was in the past, meaning that the central bank itself should be held partly accountable.

Unless the central bank restores public confidence, it is unlikely that the monetary mechanism will recover even if external forces fade away in line with a global economic recovery. Now is time for Governor Kim and the BOK to go over the effectiveness of monetary policy and brush up on the art of rhetoric.