Contribution Cost of raising benchmark interest rate
Hwang Sei-woon, Senior Research Fellow at Korea Capital Market Institute
By Hwang Sei-woon
The Bank of Korea raised its benchmark interest rate by 0.25% to 0.75 percent from its historically low 0.5 percent in August 26. One of the main purposes of the central bank raising the benchmark interest rate is to control inflation. However, the purpose of this base rate hike seems to be more clearly aimed at curbing the surge in household debt and controlling the risk of a bubble in asset prices rather than concerns about inflation.
Central banks have traditionally emphasized their role as inflation fighters. Since the 1970s, which witnessed high inflation along with two bouts of stagflation, global central banks have clearly experienced the need to control inflation. If an economy loses control over inflation, it becomes very difficult to take advantage of both fiscal and monetary policies in response to the business cycle.
In a situation where the inflation rate has risen, even if an attempt is made to stimulate the economy to respond to the economic downturn, the inflation rate easily rises, while the desired effect for the economy such as a drop in the unemployment rate is more likely to become insignificant. Liquidity supply either by fiscal or monetary policies can lead to a vicious cycle that only fuels inflation rather than economic recovery under a high inflation environment. And when they finally decided to tackle rising inflation down, the cost is quite high.
The rise in the benchmark interest rate may prevent future crises from happening as it can suppress debt growth. There is typically a limit in reducing the debt outburst only by loan regulations. It is difficult to block the high demand for funds, which is driven by a low interest rate, with a barrier to loan entry. A drop in demand by price increases rather than by loan regulation will be a more fundamental way to solve the household debt problem.
While the effect of raising the base rate is quite obvious as described, it is also necessary to clearly recognize that it will incur costs at the same time.
An increase in the base rate has the risk of dampening economic recovery by imposing a larger burden of interest payment on households and companies. It is expected that at least three or four base rate hikes will be necessary to contain the growth in household debt and the rise in real estate prices. Although the rate of debt growth may slow with base rate escalation, households will suffer from the increased interest payment burden. This can result in a decline in economic recovery by reducing households' consumption budget.
Another cost factor is that the effects of the economic slowdown due to the hike could be concentrated in Korea if we are the only one who raises the base rate. Although there is a saying that it is better to get it first if you have to go through it anyway, it may not be always the right decision to raise the interest rate first while other countries stay sluggish. It is notable that a strategy that synchronizes the pace of interest rate hikes with other global central banks is an effective tactic in most cases.
The writer is Senior Research Fellow at Korea Capital Market Institute.