Core inflation hits highest in 2 years, 7 months

Price growth seen staying above target for extended period

Further hikes possible depending on prices, economic conditions

Bank of Korea Governor Shin Hyun-song gavels open the Monetary Policy Board meeting at the Bank of Korea headquarters in Jung-gu, Seoul, on Thursday. [Yonhap]
Bank of Korea Governor Shin Hyun-song gavels open the Monetary Policy Board meeting at the Bank of Korea headquarters in Jung-gu, Seoul, on Thursday. [Yonhap]

The Bank of Korea's decision to raise its benchmark interest rate for the second consecutive time in three years and seven months reflects its priority of getting ahead of broadening inflationary pressures. With growth running hotter than expected on the back of strong exports and a recovering domestic economy, the central bank judged that inflation would remain above its target for a considerable period and that a preemptive response was warranted. Against that backdrop, the Monetary Policy Board underscored its intention to manage inflation within a "medium-term horizon" framework going forward, while signaling it would determine the timing and pace of any further rate increases based on price and economic trends.

Key indicators covering growth, prices and real estate still point toward tightening, financial industry sources said Thursday, explaining the board's decision to raise the benchmark interest rate by 25 basis points. While price pressures had eased somewhat compared with last month's meeting — when the board voted unanimously to raise rates — the bank moved decisively to counter rising demand-side inflation. The fact that only one board member dissented in favor of holding rates is seen as reflecting that same assessment.

On the consumer price front, supply-driven inflation that flared following the Iran war has been gradually subsiding, but the economic expansion led by the semiconductor sector is increasingly feeding into demand-side price pressures.

Consumer price inflation came in at 2.8 percent last month, falling back into the 2 percent range for the first time in three months. Import prices declined for two consecutive months, and producer prices also fell last month for the first time in 11 months.

Core inflation, which Governor Shin Hyun-song has repeatedly highlighted, rose 2.6 percent in July — its highest reading in two years and seven months. Core inflation strips out highly volatile items from the consumer price index and is used to gauge the underlying trend in prices.

The Bank of Korea expects that even if tensions between the United States and Iran ease, demand-side pressures from strong economic growth will continue to push prices higher. As the economy expands rapidly and wages and consumption rise, inflation faces upward pressure. Unlike supply shocks, demand-driven pressures do not subside easily, and the bank concluded that acting now is necessary to contain future inflationary pressure.

"Prices are expected to rise above the target level for a considerable period, as the pass-through of cost pressures that have built up continues and demand-side pressures gradually intensify alongside improving income conditions," Governor Shin said in the monetary policy statement Thursday. He added that "significant uncertainty remains around the future inflation path, including movements in international oil prices and exchange rates, the pace of domestic demand recovery, and the extent to which wage increases spread."

Economic growth, driven by semiconductor exports, has become more firmly entrenched. Real GDP expanded 0.6 percent quarter-on-quarter in the second quarter — three times the Bank of Korea's earlier forecast of 0.2 percent. Real gross domestic income, a measure of residents' actual purchasing power, surged 3.6 percent, outpacing real GDP growth by roughly sixfold. On a year-on-year basis, real GDI rose 15.6 percent, the largest increase since the first quarter of 1988, when it grew 16.4 percent — a gap of more than 38 years. The robust economic momentum underpins the view that a rate increase would have only a limited impact on the real economy.

The growth outlook has also been revised steadily upward. The Monetary Policy Board raised its growth forecast for this year to 3.3 percent from 2.6 percent. The Bank of Korea first projected this year's growth at 1.8 percent in November 2024, then cut it to 1.6 percent in May last year, before revising it upward in November of that year to 1.8 percent, then to 2 percent in February this year and 2.6 percent in May. The forecast for next year was also raised sharply, to 2.9 percent from 2.1 percent, reflecting expectations that semiconductor-led growth will continue to lift the economy through next year.

"The domestic economy is expected to sustain solid growth, with exports and investment continuing to expand strongly on the back of favorable semiconductor conditions, and consumer spending gradually recovering as income conditions improve," Governor Shin said. "Uncertainties remain in the growth outlook, however, including the extent to which the semiconductor boom spreads to domestic demand, developments in the Middle East, and changes in the trade environment," he added.

Financial stability imbalances also supported the case for a rate increase. Housing prices and household debt remain a source of concern. According to the Korea Real Estate Board, the average sale price of all housing types in Seoul — apartments, row houses and detached homes — rose 1.09 percent month-on-month in July, with the rate of increase climbing for four consecutive months since April, when it stood at 0.55 percent, reaching its highest level this year. South Korea's household debt also surpassed 2,000 trillion won ($1.44 trillion) for the first time in history in the second quarter. "Housing prices in the Greater Seoul area continued to rise sharply, and household lending also increased by a significant margin," Governor Shin said.

The won-dollar exchange rate, which had been running persistently high, has been gradually stabilizing at lower levels. After hovering in the 1,500-won range, the rate has been falling steadily since July. The weekly closing rate on Wednesday stood at 1,397.7 won per dollar, dropping into the 1,300-won range for the first time in about 11 months. Significant uncertainty remains in the outlook, however.

The rate increase narrowed the gap between South Korean and US benchmark rates — measured against the upper bound of the US target range — by a further 25 basis points, to 0.75 percentage points from 1 percentage point. Since the Korea-US rate inversion that began in 2022 has been one of the root causes of the persistently high exchange rate, the latest hike is expected to exert additional downward pressure on the won-dollar rate.

"High volatility in key price variables persisted in financial and foreign exchange markets," Governor Shin said. "The won-dollar exchange rate fell sharply as foreign exchange supply-and-demand conditions improved — partly due to a slowdown in foreign equity outflows — and as the US dollar weakened," he added.


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