Soaring Prices Push South Korea’s Real Policy Rate to 3-Year, 2-Month Low

Surging consumer prices have pushed the real policy rate felt by South Korean households and businesses to its lowest level in three years and two months. The real policy rate, calculated by subtracting consumer inflation from the nominal benchmark rate, has fallen deeper into negative territory, increasing incentives to borrow and potentially adding liquidity to the economy. That, in turn, is adding to the case for the Bank of Korea to raise interest rates.

Data from the Bank of Korea and the National Data Portal showed on June 3 that the real policy rate based on May consumer inflation fell 0.5 percentage point from the previous month to minus 0.6% a year. That was the lowest since March 2023, when it stood at minus 0.7% as inflation surged in the wake of the Russia-Ukraine war. The figure was derived by subtracting the consumer inflation rate of 3.1% from the benchmark rate of 2.5%.

The real interest rate is based on the Fisher equation proposed by US economist Irving Fisher. Central banks and economists use it as a key gauge of whether monetary policy is tight or loose.

The drop in the real policy rate reflects a renewed pickup in inflationary pressure. Consumer inflation came in at 3.1% in May, matching March 2024 and reaching its highest level in two years and two months. A 24.2% surge in petroleum prices, driven by the war in the Middle East, led the increase.

The BOK said inflation is expected to remain in the 3% range for the time being as global oil prices stay elevated. If the benchmark rate remains at 2.5%, the real policy rate will probably stay negative as well. Negative real rates lower the effective borrowing cost for households and businesses, which can spur loan demand. The resulting increase in liquidity could flow into asset markets and deepen financial imbalances. That has strengthened the case for the BOK to raise its benchmark rate in July.

Kim Ik-hwan, Hankyung.com reporter, lovepen@hankyung.com