3.25% is the ’new neutral’ BOK base rate

By Tim Condon

PIMCO chief executive Mohammed El-Erian coined the phrase “new normal” to describe the post-global financial crisis world of slower growth and lower bond yields. In the new normal, the neutral level of the central bank’s policy interest rate will be lower than before the crisis.

This is a second new normal for Korea. The first followed the Asian financial crisis. Nominal growth domestic product (GDP) growth slowed from 15.9 percent in the pre-Asian crisis period, which we define as starting in the first quarter of 1987 and ending in the second quarter of 1997, to 7 percent in the post-Asian crisis period up to the crisis, which we define as starting in the third quarter of 1999 and ending in the second quarter of 2008.

Government bond yields depend on expected growth and inflation so a slowdown in nominal GDP growth means a decline in bond yields. The yield on 3-year AA- corporate bonds, which we use as a proxy for the benchmark 3-year Korea Treasury Bond because of a lack of historical data on latter and the high correlation between the two, averaged 14.4 percent during the pre-Asian crisis period and 6.3 percent in the post-Asian crisis period.

Korea’s second, post-global financial crisis’ new normal is associated with lower bond yields, from which we infer that trend nominal GDP has slowed. The average yield on the benchmark 3-year KTB has fallen to 3.8 percent since the global financial crisis (July 2009 to latest) from 4.7 percent from January 2004 to June 2008. There are too few observations to calculate a new trend but real GDP growth has averaged 3.9 percent since the initial snapback from the crisis, well short of its 4.7 percent post-Asian crisis average. There is no reason to think trend inflation has accelerated to offset the impact of slower real GDP growth on nominal GDP growth.

Slower nominal GDP growth means a lower neutral level of the base rate, where “neutral” refers to the level that would prevail when the risks to the economy are equally balanced between growth and inflation.

We estimate the “old neutral” base rate at 4.3 percent, its average during the post-Asian crisis to pre-global financial crisis period. The “new neutral” base rate should decline by something like the slowdown in nominal GDP growth (and the fall in the average 3-year KTB yield). Based on these, the prevailing level of the base rate, 3.25 percent, is a reasonable estimate of the new neutral.

Stable growth and slowing inflation argue for the BOK to remain on hold. Our 2012 real GDP growth forecast is 3.9 percent, and unchanged from our estimate of 2011 growth. The October Consensus Economics forecasts are 3.8 percent for 2011 and 2012.

We estimate inflation at 4.5 percent this year (Consensus Economics 4.3 percent), above the BOK’s 2-4 percent medium-term inflation target. However, much of this is coming from the consumer price index (CPI) food component. Food price spikes typically are short-lived and we forecast inflation slowing to 3.0 percent in 2012 (Consensus Economics 3.2 percent). There is no case for moving the policy interest rate away from its neutral level if the economy grows at trend and inflation is slowing.

ING’s forecast for the major advanced economies _ below-trend growth with central banks on hold until 2013 _ is neither positive enough to warrant forecasting a BOK rate hike nor negative enough to warrant forecasting a BOK rate cut. The BOK almost certainly would cut the base rate in the event of a coordinated G20 easing. But a “Lehman moment” of the kind that triggered the 2008 action can never be the baseline scenario.

Bottom line: The new normal in Korea is 3.9 percent real GDP growth. The new neutral BOK base rate is 3.25 percent, which we forecast remaining unchanged through 2012.