Seoul: As the Bank of Korea raises rates to curb inflation, planned fiscal expansion risks keeping borrowing costs higher for longer. The Bank of Korea's (BOK) Monetary Policy Board raised its benchmark interest rate Thursday from 2.75 percent to 3 percent, marking a second consecutive monthly increase. Given the usual practice of waiting to assess the effects of one rate increase before making another, the move is unusual. Monetary policy is clearly shifting toward tightening.
According to Yonhap News Agency, recent macroeconomic indicators provide justification. Consumer inflation remained above 3 percent in May and June. Although it eased to 2.8 percent in July, it remains above the central bank's 2 percent target. The Middle East war and mounting demand-side pressures have also increased the risk that high inflation will persist.
The BOK expects economic growth of 3.3 percent this year and 2.9 percent next year, with core inflation reaching 2.5 percent in both years. BOK Gov. Shin Hyun-song said acting before inflation spreads further could ultimately reduce the cost to the economy. Citing a Korean proverb about fixing a problem early before it requires far greater effort, he said the central bank had chosen to act preemptively.
But the burden of a 3 percent benchmark rate should not be underestimated. As gaps widen between exports and domestic demand, and between large corporations and smaller businesses, higher borrowing costs will fall disproportionately on vulnerable parts of the economy and deepen polarization. Household debt has already surpassed 2 quadrillion won (US$1.45 trillion). People who stretched their finances to buy homes and heavily indebted self-employed business owners could be pushed closer to their limits. The government needs macroprudential measures to prevent financial instability alongside targeted policies to protect vulnerable borrowers.
Another concern is the disconnect between monetary and fiscal policy. While the BOK is tightening liquidity, the government has signaled that next year's budget will exceed 800 trillion won (US$580 billion). Such fiscal expansion risks weakening monetary tightening and prolonging the pain households and businesses must endure. Amid turmoil in global sovereign bond markets and expectations of greater government spending, the yield on Korea's 10-year government bond has surged to 4.27 percent.
The government should heed that market signal. When the central bank is raising rates to contain inflation, fiscal policy should not work aggressively in the opposite direction. Otherwise, policymakers risk forcing interest rates to remain higher for longer and increasing financing costs across the economy. To reduce uncertainty and restore coherence to economic policy, the government should avoid using higher-than-expected tax revenue as justification for indiscriminate spending. Instead, it should use additional fiscal resources to repay national debt proactively.