KDI Economic Outlook 2022-1st Half US Rate Hikes and Korea’s Policy Response May 16, 2022
May 16, 2022
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Kyu-Chul Jung
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- Summary
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■ The US is raising base interest rates in keeping with rising inflation and solid economic recovery. The analysis finds that its macroeconomic impacts on Korea vary depending on the causes of the US rate hikes and the monetary policy responses of Korea.
- The US and Korea responded by raising interest rates to the US positive demand shock since an increase in demand puts upward pressure on prices and economic conditions in both countries.
- When Korea follows the US and raises interest rates after the US rate hike shock, an economic downturn in the US spills over into the Korean economy as is. On the contrary, monetary independence serves as a buffer against substantial effects of the shock but temporary inflation.
- The analysis shows that independent policy in line with domestic price levels and other economic conditions yields greater utility than the interest rate synchronization system from the viewpoint of social welfare.
■ Korea’s monetary policy should tolerate capital flows and exchange rate fluctuations and operate congruently with domestic inflationary and economic conditions.
- Korea’s inflation has remained elevated, far above the target rate, and this situation calls for raising the base rate to achieve price stability.
- However, the policy rate gap between the US and Korea should be allowed, which may arise from the difference in their inflation levels and economic conditions.
- Meanwhile, considering that currency volatility serves as a mechanism to adjust the imbalances between countries and absorb external shocks, the policy needs to tolerate the fluctuations in exchange rates and refrain from intervening in the forex market in line with the purpose of the floating exchange rate system.
- Furthermore, since macroeconomic soundness is essential to cushioning external economic shocks, the existing strong macro-prudential policy stance needs to be sustained for the time being in this phase of recovery from the COVID-19 crisis.
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The U.S. Federal Reserve has recently indicated a swift interest rate hike in response to high inflation.
While some argue that South Korea should adjust its interest rates in line with the U.S. increase, others believe that we should first consider the economic conditions in Korea. How should we respond?
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The U.S. has accelerated its base rate hike in an effort to control high prices.
The impact of the U.S. rate hike on the Korean economy will depend on whether Korea raises its key interest rate in line with the US or responds to domestic economic conditions and prices.
We began by developing two scenarios for the U.S. interest rate hike, one based on an increase in demand and the other not. We then analyzed the potential impact of each scenario on the Korean economy.
In the scenario where the U.S. rate hike is driven by increased demand, this resulted in a surge in demand for Korean products and a corresponding rise in domestic prices and economic activity.
In this case, both countries would increase their benchmark interest rates, meaning no significant difference in their monetary approaches.
Under the independent monetary policy, Korea's base interest rate hike is lower than that of the US, as its demand growth is lower compared to that of the U.S.
In this scenario, during the first quarter, Korea's economy and prices received a boost as the won-to-dollar exchange rate increases.
But, starting in the second quarter, prices began to stabilize rapidly as a result of a gradual decline in the exchange rate of the won, which has lower interest rates.
Now let's consider a different scenario where the U.S. raises its rate hike for reasons other than an increase in demand.
If Korea were to follow suit with a similar rate hike, the economy would also experience a slowdown similar to that of the U.S.
Since benchmark rates are rarely modified under independent monetary policy, the scenario resulted in price hikes during the first quarter due to rising exchange rates. However, prices stabilized swiftly in the second quarter, mirroring the outcome in the previous scenario where the U.S. rate hike is driven by an increase in demand.
As a result, Korean product prices become more competitive, having no significant impact on the economy.
Other than temporary inflation, there appear to be no other effects that followed.
Additionally, the independent monetary policy resulted in a 0.04% increase in consumption at each time point, indicating better social welfare improvement effects compared to the rate synchronization option.
In light of this, what is the appropriate course of action for Korea in response to the U.S. rate hike?
(Interview with Kyu-Chul Jung, Director of Office of Macroeconomic Analysis and Forecasting, KDI)
The Korean economy is currently facing high inflation but expected to see a boost in private consumption as social distancing measures are lifted.
To stabilize inflation, Korea will need to raise its benchmark interest rate gradually, but not as steeply as the US, which has a stronger economic recovery and higher inflation rate. It's important to recognize the gap in benchmark interest rates caused by differing economic conditions in the two.
While there are concerns about possible capital outflows from Korea due to the interest rate gap, large-scale outflows have not occurred since the 2000s, even when interest rates were reversed.
It's worth remembering that capital flows and exchange rate fluctuations can act as mechanisms to absorb any potential outflows.
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