The Federal Reserve Board decided to raise base rate Wednesday (local time) by 0.25 percentage point from 1.75-2 percent to 2-2.25 percent, widening the gap between Korea’s base rate, which currently stands at 1.50 percent. The interest rate hike comes after three months since the U.S. raised the rate in June, the third time this year. Such hikes reflect U.S. confidence of the economy and its ability to absorb money in the market.
The Monetary Board of the Bank of Korea called a contingency meeting and concluded that the interest rate gap would not severely impact the financial market. The Ministry of Strategy and Finance explained that there are hardly any concerns of capital flight, such as the events observed in Turkey, Argentina and other emerging economies. Nonetheless, the U.S. interest rate hike and the widening gap with Korea’s rates are perplexing, as it reflects the economic conditions of the two countries.
The reason why the Bank of Korea cannot afford to raise rates is that Korea lacks economic confidence, unlike the U.S., which is growing at an annual 4.1 percent. Higher interest rate means less liquidity, which is good for price stability, but can negatively impact business activities, consumption and overall economic performance. The Bank of Korea also reduced forecasted growth for this year from 3.0 percent to 2.9 percent, but even this revised target is viewed as unattainable. With debt of the self-employed reaching 300 trillion won, higher interest rates would deal a direct blow to small businesses, which are at risk due to higher minimum wages. With employment indicators at its worst, a more stagnant economy would imply worse employment conditions.
The interest gap between the two countries may not be an immediate threat, but it will inevitably pose a burden to the Korean economy for the longer term. If Korea seeks to resolve financial anxieties such as bulging household debt of 1,500 trillion won and risk of capital flight, it is critical to strengthen economic and employment fundamentals that remain robust in external changes such as higher interest rates. To this end, Korea needs to encourage capital to flow into more productive areas of its real economy and create environments where businesses are encouraged to invest.