Room for further rate reduction

By Matthew Circosta

Economist at Moody’s Analytics Australia

The Bank of Korea cut the interest rate by 25 basis points to 2 percent in October, the second such reduction in three months. September’s price data, which showed a troubling slowdown in inflation, reflects a weak economy that needed additional stimulus.

Concerns about Korea entering a Japan-style low-growth and deflationary environment are prompting fiscal and monetary policymakers to act boldly. At 2 percent, the interest rate sits at the level that prevailed throughout the recent global financial crisis.

Deflationary forces are present across the globe. Prices are falling in parts of Europe and deflation could re-emerge in Japan if the economic recovery there falters. U.S. inflation remains weak and prices are on a downtrend trend in China.

Korean inflation data mirrors these trends. The headline inflation rate has sat in the 1 percent to 1.5 percent range for about two years, while the core rate has been only slightly stronger at around 2 percent.

Tepid upstream price pressures― evident in declining producer prices ― suggest limited upward pressure in consumer prices in the near term.

Price risks in Korea are also weighted to the downside in the long run. Demographic trends will cause the working-age population to fall in the coming years, which will reduce the economy’s growth potential and cap price growth.

The economy has also lost significant growth momentum in recent months because of weakness in the domestic market. GDP growth is now tracking at an annual rate closer to 3 percent after averaging 3.8 percent in the first half of 2014. Moreover, the currency’s strength against key trading partners in U.S., China and Japan is hurting exporters and creating headaches at the central bank.

The government and central bank are effectively working together to boost economic growth. The government announced an expansionary 2015 budget and enacted new stimulus and reform measures to spur domestic demand.

On the monetary side, rate cuts should help weaken the Korean won, improving the price competitiveness of underperforming exporters.

The BOK is concerned that lower rates could stoke capital outflows, but Korea’s solid economic and financial fundamentals should limit any drag.

There are signs that lower rates are already providing a boost to confidence and demand, and monetary stimulus should continue filtering through the real economy in coming months.

Prospects for employment, consumption and incomes have brightened. The government’s focus on lifting wages, as part of its reform agenda, and efforts to lift female workforce participation, improve child care services, and reduce regulations for small business should also generate greater employment, in turn supporting household incomes, confidence, and willingness to spend.

The economy’s sluggish growth and slack in the labor market means it will take time before inflation increases at a faster pace.

If concerns over the economy and deflation intensify, the BOK will be compelled to cut rates to a new record low, so price data bear close watching. The monetary bias is for even lower rates in the coming months.