The U.S. Federal Reserve raised its benchmark interest rate by 0.25 percentage points to a range of 1.75 to 2 percent Wednesday. It was the first time in a decade the Fed bumped up its benchmark interest rate to the 2 percent range. The U.S. central bank signaled two more similar increases are on the way within this year.
This means the gap between U.S. and Korean policy rates could widen to 1 percentage point if the Bank of Korea does nothing. In mid-2006, the last time the rate gap between the two countries stood at 1 percentage point, Korea suffered a net capital outflow of 8.2 trillion won ($7.65 billion) from the local stock and bond markets.
Local economists rule out such a development, saying the impact of the U.S. rate hike will be limited this time around. They cite Korea's strong economic fundamentals, including ample foreign reserves and the current account surplus for 74 consecutive months. “There is a slim chance of a drastic funds outflow,” Deputy Finance Minister Ko Hyung-kwon said after a meeting with the BOK.
The monetary authorities can ill afford to remain complacent, however. Above all, the continuous U.S. rate hike and corresponding moves here are highly likely to push up market rates, squeezing further the debt-ridden households and marginal small- and medium-sized businesses. The rise in commercial rates will also lead to declines in consumption and investment, hampering economic growth.
At stake is when the central bank will raise its benchmark rate, and how. Given the weak recovery, the BOK cannot immediately follow the example of its U.S. counterpart. Nor can it allow the wide rate gap to remain for long, considering the possibility of funds drain. The finance ministry and central bank will have to decide the timing and scope of a rate increase through close consultation.
The monetary authorities also ought to take pre-emptive moves to minimize the adverse effects of higher interest rates. Other economic players, including businesses and households, should also remain ready to return to an era of “normal” interest rates.