Macro Insights Weekly: Rate hike considerations in India and South Korea
- Mass vaccination and ongoing economic recovery will likely nudge BOK to start raising rates in 4Q21
- This would be a shift of priority from supporting growth to safeguarding price / financial stability
- India is struggling with pandemic management while inflation risks remain skewed to the upside
- As the second wave ebbs and vaccination spreads, RBI is likely to outline normalisation plan for 4Q
Commentary: Rate hike considerations
Economic recovery may be fledgling, and the pandemic situation is by no means settled, but Asian central banks will not be able to wait for the Fed act before beginning policy normalisation, in our view. Two economies are at the forefront of rate hike considerations, although with varying motivations.
Mass vaccination and a fuller recovery will likely provide the needed conditions for the Bank of Korea (BOK) to normalise monetary policy, shifting the priority from supporting growth to safeguarding price and financial stability.
Inflation is already rising faster than expected, exerting pressure on the BOK. Headline CPI jumped to 2.6% YoY in May, above the BOK’s 2% target for the second month in a row, and the highest reading over nine years. Consumers’ expected inflation rate for the next one year also climbed above 2%, reaching 2.2% in May. Given the ongoing price momentum and the rise in inflation expectations, CPI numbers are likely to stay above the 2% mark in 3Q and retreat only slightly to 1.5-2% in 4Q.
The rapid rise in property prices and household borrowings also puts pressure on the BOK. Notwithstanding the government’s tightening of tax measures, residential property prices continued to surge 13% YoY in May, the fastest pace over 18 years. Banks’ household loans registered double digit growth for the tenth consecutive month in May, at 11% YoY. As debt growth continues to outpace nominal GDP, household debt to GDP ratio is likely to rise to a new record high of 110% by the end of this year.
There are clear signals from the BOK that rate hikes will come earlier than expected. Governor Lee Ju-yeol flagged the possibility of rate hikes last month, saying that rate normalisation will come at “an appropriate time by the end of the year”.
The pace of rate hikes will likely remain gradual, based on historical experience. During the policy normalisation cycles in the past two decades, the BOK delivered 50-75bps hikes per year in 2005-07 and 2010-11, and 25bps hike per year in 2017-18. Notably, the neutral rate level has drifted lower in the recent decade, as a result of the structural decline in GDP growth and inflation.
We now expect the BOK to start to raise rates in 4Q, and deliver 25-50bps hikes per year during the upcoming cycle. The benchmark repo rate is expected to be lifted to 0.75% by the end of this year, and further to 1.00% by mid-2022 and 1.25% by end-2022 (reverting to the pre-pandemic level seen in Dec19).
CPI inflation has stayed above 4% target since October 2019, keeping the FY20 average inflation at 4.8% and FY21 at 6.2%. Our forecast for FY22 at 5.5% suggests that annual inflation is on course to staying above target for three successive years.
Inflation risks for 2021 remain skewed to the upside, especially core readings, on higher commodities mainly energy, rising input prices, rigidity in fuel taxes and idiosyncratic factors (e.g. temporary spurt owing to the pandemic in medical costs, education, personal services etc.) apart from a likely return in demand impulses as growth gains traction. A normal monsoon and strong domestic production are expected to cool non-imported food pressures beyond the seasonal swings.
Both WPI and CPI inflation indices have quickened in recent months, but the wholesale price index has outpaced retail inflation, as the former is more correlated to global commodities. Wholesale price inflation also impacts manufacturers, who have absorbed most of the input price increases for now, but as recovery gains traction, part of these is beginning to get passed to the consumers (selected consumer durables etc.).
A 1 percentage change in WPI core (non-food manufacturing) translates into a small 0.2ppt to CPI core goods inflation and much smaller for overall CPI core and headline inflation, according to a RBI study. While pass-through risks remain low, the monetary policy committee is likely to be concerned that supply-side pressures might be supplanted by demand-led forces as the second wave subsides and sequential growth gains momentum.
Rising inflation benefits borrowers and hurts lenders. Inflation-adjusted real rates have been in negative for more than a year, with the repo rate at 4%, eroding returns from banks’ deposits and incomes, thereby incentivising a push towards riskier assets/investments. Real incomes are also falling, particularly in midst of the pandemic. The bite is harder for the rural consumers where the terms of trade is turning negative as non-food inflation is rising at a faster clip than food (proxy for incomes), whilst fiscal support has been scaled back and the second wave has hit the rural areas more adversely.
Minutes of the June policy review were broadly dovish as the members backed the need for policy support to boost recovery amidst the second Covid wave. Inflation was expected to stay elevated but due to supply-side pressures and be temporary. These remarks were however made before the May CPI inflation release, with June numbers (~6.8%) to be also available by the August meeting.
Factoring these in, the RBI monetary policy committee might begin to express more concern over inflation at August’s rate review. As the second wave ebbs and vaccination rate catches up on better supplies, the central bank is likely to outline normalisation plans for 4Q21.
Communication will be key to ensure financial tightness doesn’t front-run the intended speed of normalising policy, emphasising that normalisation does not equate tightening. Draining surplus liquidity is likely to be accompanied by a calibrated increase in the reverse repo rate from the current 3.35% to 3.75% - reinstating the 25bps corridor below the repo rate. Subsequent moves will include a shift in the policy stance from accommodative to neutral, before considering rate hikes. Rate hikes are likely to start in 2H22.
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