BOK base rate is still too high
We forecast another 0.25 percent rate cut to 2.75 percent in the current quarter. Because the cut will improve monetary policy we expect it to be positive for the KOSPI and the won and negative for Korean Treasury bonds.
Even after the surprise 25 basis point (bp) Bank of Korea base rate cut we think it’s still 25bp too high. During the last complete policy cycle, which commenced in May 2003 and ended in September 2008, it averaged 4.1 percent, which we consider the neutral level of the policy rate. Other things equal, the neutral level of the policy rate shouldn’t change.
The global financial crisis changed things, however. The crisis was a massive demand shock. The 42 percent peak-to-trough fall in exports caused the manufacturers’ inventory-to-shipments to spike, triggering a sharp cutback in production and employment. Korea’s subsequent growth path resembles Japan’s more than Taiwan’s.
By the first quarter of 2009 real GDP had fallen 8 percent below its long-term growth path. However, as occurred in Japan but not in Taiwan, monetary policy allowed nominal spending to fall in lock step with real spending _ in Japan BOJ policy actually amplified the decline in real spending. As of the first quarter of 2012, real and nominal spending were still 5 percent to 6 percent below their long-term growth paths.
Not only was BOK policy too tight during the global financial crisis, we think elevated policy uncertainty imparted a tightness to policy when the BOK started normalizing the base rate. Policy uncertainty prevented nominal spending growth expectations from quickly bouncing back to their pre-crisis trend path as occurred in Taiwan. A comparison of analyst forecasts for BOK meetings with actual outcomes for comparable periods from the start of the last two tightening cycles reveal that surprises have been more common in the current cycle and the average dispersion of forecasts has doubled.
We estimate the new normal trend nominal spending growth is around 5.4 percent, down from 6.9 percent before the crisis. We know that nominal GDP growth will split between real growth and inflation. Based on our estimate that Korea’s trend growth rate of real spending slowed to 3.4 percent from 4.6 percent, most of the slowdown in trend nominal spending growth came from lower real spending growth.
The neutral level of the policy interest rate should move with the change in nominal spending growth. Based on our estimate of the slowdown in nominal spending growth, we think the new neutral level of the Base Rate is around 2.75 percent, the 4.1 percent old neutral minus 1.25 percent to 1.50 percent for estimated lower trend nominal spending growth.
Worries that such a “low” nominal base rate would imply a negative real rate because of high consumer price index (CPI) inflation are baseless. The real rate is the nominal rate minus expected inflation. We estimate that average inflation in the GDP deflator, the broadest measure of inflation, has fallen to 2 percent since the crisis from 2.2 percent before. Inflation in Korea is volatile, which we attribute to poorly anchored inflation expectations. Poorly anchored inflation expectations impart volatility to the real interest rate but don’t change its average. We estimate the new neutral real base rate at around 0.75 percent, which adjusts the previous rate for the estimated slowdown in trend real spending growth.
We correctly forecast the 0.25 percent base rate cut at the July BOK Monetary Policy Committee (MPC) meeting. We believe the MPC’s assessment of the balance of risks to the economy has shifted to growth from inflation. We agree with BOK Governor Kim, who recently said inflation was unlikely to exceed the 3 percent mid-point of the BOK’s 2 percent to 4 percent inflation target and we recently cut our 2012 inflation forecast to 2.5 percent from 3 percent (2.7 percent year-to-date).
On the other hand, the BOK has downgraded its GDP growth forecast twice this year, most recently in April to 3.5 percent from 3.7 percent. We consider a third downgrade likely. Following the release of the May industrial production and service industry output data we revised our estimate of second quarter growth to 1.7 percent from 3.3 percent and our full-year forecast to 3 percent from 3.4 percent.
We forecast another 0.25 percent base rate cut in the current quarter, which would bring the base rate more into line with the economy’s post-crisis growth and inflation fundamentals. For this reason it would be positive for risk assets like the KOSPI and the won. With the three-year Korea Treasury bond yield hovering at the base rate (latest 3.03 percent) a rate cut would be positive for Korea Treasury bonds other things equal. However, other things are not equal. Bond yields are where they are partly because monetary policy is too tight. In our view increased monetary accommodation will be negative for bonds.