Written response submitted to lawmaker Lee Jong-wook's office

BOK cites 6 studies supporting 'preemptive hike' rationale

Positive effects found, but three conditions apply:

① High debt levels raise financial stability risks

② Central bank must be confident about terminal rate

③ Large hike increments can weigh more heavily on growth

Bank of Korea Gov. Shin Hyun-song speaks at a Monetary Policy Board briefing on monetary policy direction at the Bank of Korea in Jung-gu, Seoul. [Yonhap]
Bank of Korea Gov. Shin Hyun-song speaks at a Monetary Policy Board briefing on monetary policy direction at the Bank of Korea in Jung-gu, Seoul. [Yonhap]

The Bank of Korea has released research supporting preemptive interest rate hikes, as Gov. Shin Hyun-song raised the benchmark rate for a second consecutive month last month, invoking a Korean proverb about acting early to avoid greater effort later. The studies collectively argue that front-loading tightening reduces its overall cost, while attaching conditional caveats that effectiveness depends on debt levels, central bank communication, and the size of rate increases.

According to a written response the BOK submitted to the office of People Power Party lawmaker Lee Jong-wook of the National Assembly's fiscal and economic planning committee, the central bank cited six studies as the basis for Shin's statement last month that "preemptive policy action can reduce the intensity and duration of tightening and ease the burden on growth compared with a delayed response." Shin made the remarks after raising the benchmark rate for a second straight time, from 2.75 percent to 3 percent, emphasizing the need for a proactive approach.

The studies found that preemptive rate hikes can anchor inflation expectations early, slowing price increases sooner, and can shorten the time it takes for the policy rate to return to pre-hike levels. Some analyses found that economies that acted early were more likely to achieve a soft landing without a recession, compared with cases where rate responses were delayed. Other research showed that when central banks moved quickly, the magnitude of hikes was smaller and the drag on growth during the inflation-containment process was reduced.

However, the studies identified three broad conditions for preemptive rate hikes to be effective.

The first is a manageable level of debt. Paolo Cavallino, a senior economist at the Bank for International Settlements, and co-authors warned in a paper titled "Front-loading monetary tightening: pros and cons" that preemptive monetary tightening can heighten financial stability risks in environments where private or public debt levels are high or market liquidity is unstable.

A BIS report titled "Hard or soft landing?" by Principal Economist Frédéric Boissay and co-authors similarly noted that "when asset prices — especially real estate prices — are elevated and non-financial sector debt is high, the response to monetary policy can be amplified," adding that "this risk is particularly large in countries where variable-rate lending is common."

According to BIS data, South Korea's non-financial sector debt reached 6,514.56 trillion won ($4.79 trillion) at the end of last year, up about 4.5 percent from 6,233.98 trillion won a year earlier. Of that total, government debt rose 9.2 percent to 1,216.64 trillion won, while household debt increased 3 percent to 2,359.72 trillion won.

The share of variable-rate lending is also growing. According to the BOK, variable-rate mortgages accounted for 68.1 percent of newly extended home loans in July — the highest share in 12 years and five months.

The second condition is central bank credibility. The "Front-loading monetary tightening: pros and cons" paper stated that "for a central bank to decide on preemptive rate hikes, it must be fairly confident about the terminal rate during the tightening cycle," warning that acting preemptively "can actually be harmful when the degree of tightening needed to bring inflation under control is uncertain." If inflationary pressures persist longer than expected, the central bank's credibility can come into question, potentially triggering an outsized reaction in financial markets.

Robert J. Tetlow, a former senior adviser at the Federal Reserve, argued in a paper titled "How Large is the Output Cost of Disinflation?" that "the more responsive expectations formation is to policy actions and communication, the lower the output cost of disinflation."

The third condition concerns the size and pace of rate increases. A paper titled "Soft landing and inflation scares" by former St. Louis Federal Reserve Bank President James B. Bullard and co-authors argued that "the timing of the policy response to an inflation surge is more decisive than its intensity," while also cautioning against excessively large hike increments. The larger the single-move increase, the more effectively it can cool a price surge — but the greater the potential damage to growth, the paper found.

On the timing of any further rate hikes, the BOK said it needs to closely monitor how much the recently re-escalating tensions in the Middle East will push up cost-side inflation pressures through rising international oil prices, and the extent and speed to which export strength centered on the semiconductor sector feeds through to domestic demand and demand-side inflation pressures. The central bank added that the lagged effects of rate hikes carried out so far also need to be taken into account.


kimstar@heraldcorp.com