Running out of capacity
23 January 2018
Late last year the Bank of Korea (BoK) became the first central bank in Asia to hike policy rates in the current cycle. The move highlighted the ongoing tussle between lacklustre domestic fundamentals and a buoyant global cycle. However, did it represent a tipping point? Based on last week’s policy meeting, the Bank is keeping its options open. Policy was unanimously kept on hold while a smattering of dovish rhetoric kept the Korean won in check. However, the underlying tension has failed to subside. Buoyed by solid exports growth and continued recovery in consumption, the Bank has been forced to revise up its GDP estimates again. With growth now estimated at 3.4% year-on-year in H2 2017 and 3.2% in H1 2018, versus the Bank’s 3% estimate of potential growth, the erosion of spare capacity will continue. However, this was insufficient to sway the BoK’s price outlook, with 2018 CPI inflation forecast actually downgraded from 1.8% to 1.7%. This revision came as somewhat of a surprise to the market given higher oil prices and a 16.4% hike in the minimum wage (effective on 1 January 2018). However, we think it speaks more to changes in the portion of the inflation basket that are driven by technical factors, such as prices for rents and public services, than the domestic economic cycle. Indeed, housing, health and education components, which make up 25% of the basket, have all seen lacklustre growth of late for this very reason (see Chart 8). Furthermore, the sensitivity of the remaining portion of the basket to domestic economic conditions is falling due to a range of forces, such as globalisation and technology.
The dilemma for the Bank then is whether its price target has the same powers in guiding policy to a healthy economic equilibrium? The BoK will resist any challenge to the orthodoxy of price targeting but it must also recognise the current situation is not sustainable forever. For now, the Bank will argue that policy rates are consistent not only with its price target but also its limited financial stability mandate. Having witnessed a 10 percentage point increase in household-debt-to-GDP in the last three years, the Bank is worried that anything other than a gradual policy normalisation would be destabilising (see Chart 9). We think this provides convenient cover. However, given the Bank plays second fiddle to the financial regulator concerning financial stability risks and that empirical evidence points to high costs if policy reacts excessively to household debt in the form of more inflation volatility, we think it will soon need to confront its policy dilemma. If the country continues to see global and domestic growth outperform we suspect the Bank will be forced to adjust policy more aggressively than the 1.5 hikes priced in for 2018.
Of course, the BoK is not the only central bank wrestling with these issues in the region. Growth in Japan is tracking along far ahead of potential, without translating to price trends consistent with policymakers’ price target. The key difference relates to the persistence of the Bank of Japan’s inability to meet its price target, which has permeated expectations for low inflation far into the future. This can only be rectified by a monetary policy shock capable of altering risk-taking behavior. Judging by recent survey data and market measures, inflation expectations are recovering from their recent lows but remain below levels consistent with the Bank’s price target. Policy normalisation remains a distant prospect.