Central bank needs to cut interest rates
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By Lee Myong-hwal
After the monetary policy committee of the Bank of Korea (BOK) left the policy rate unchanged in January, and contrary to market expectations, another month passed without seeing a change in the rate.
Probably it was a cautious move by the BOK, reflecting a tepid recovery of the world economy and a slowing pace of the appreciation of the Korean won. However, the economic circumstances both at home and abroad indicate that the best timing for a rate cut might have been missed.
Uncertainties in the global economy and downside risks have subsided compared to last year. In the U.S., the precipitation over a fiscal cliff was dramatically avoided at the last moment, worries over a hard landing of the Chinese economy have been mitigated, and the eurozone’s fiscal crisis has quieted down as well. Economic indicators in major countries are looking up, albeit at a moderate pace.
It seems that the worst is behind, and yet, a full recovery is likely to take time. In China, the economic growth rate is expected to be higher than last year’s mid-7 percent figure. However, as the newly elected Xi Jinping government pursues a new development paradigm, the sharp growth of the past might not be revived. Meanwhile, the U.S. economy depends on how the sequestration unfolds in the coming months, but there is a general consensus that the economic growth rate will be at the 2 percent-range this year. Across the Atlantic, the European economy will maintain the status quo or even contract, still mired in the aftermath of the fiscal crisis. Under this global environment, Korea will have a harder time with exports, especially due to quantitative easing in Japan under the so-called Abenomics, rendering the Korean currency less competitive.
Combined together, these will gingerly push the Korean economy forward, putting it between a full-fledged recovery and a continued slowdown. The recovery will be barely perceptible. The real GDP growth rate will slightly rise from the last year’s 2 percent to the upper-2 percent range. In this case, it will be an unprecedented event for the Korean economy to grow under 2 percent for two years in a row, except for the time of the global financial crisis in 2008-09. For these reasons, it was necessary to cut the base rate.
Done timely, the base rate cut would have helped slow down global capital inflows and the appreciation of the Korean won amid near-zero interest rates in the U.S. and Japan and their massive quantitative easing. Among the emerging market economies, Korea is quite an attractive bond market with a sound sovereign credit rating and a relatively high interest rate. The BOK’s reluctance to adjust the benchmark rate seems inconsistent with the government’s struggle to keep capital flows under control, as it even ponders over whether to charge taxes on FX transactions and bond trades.
Now could be an especially good timing to lower the benchmark rate as there is little concern of adverse effects. Inflation should not be an obstacle as the growth rate of consumer prices is falling below the inflation target. Another concern is mounting household debts, but this is already past the point where the lower rate would lead to more loans. On the contrary, the lower rate could alleviate households’ burden for interest payments.
It is quite regrettable that, despite all these forces underpinning the need for the rate cut, the BOK maintains an overly conservative and reserved position. In terms of the business cycle, the best timing would have been last December, or it should have been done by February at the latest, in consideration of the overall economy including the exchange rate.
The BOK’s ill-timed hesitance might also undermine the credibility of its monetary policy. If it leaves the rate unchanged, the BOK will be blamed for the weak economic recovery. On the other hand, if it cuts the rate in the coming months while the economic circumstances remain more or less the same, it will still be criticized for a lack of policy consistency. Some say that monetary policy is an art rather than science. Many are waiting to see what artistic moves the BOK will make to get out of its present quandary.