Since the outbreak of the Middle East war in late February, inflation concerns have mounted, but the prevailing market view was that central banks would not respond to supply-side, cost-push inflation pressure by raising policy rates. There were expectations of so-called "strategic patience" — refraining from overreacting to short-term variables.
However, the mood shifted at the end of March as the war dragged on. The view has emerged that the Bank of Korea (BOK) will find it difficult to avoid raising its benchmark rate. No ceasefire agreement has been reached in the Middle East war, and even if hostilities end, it is increasingly likely that the normalization of crude oil supply will take considerably longer. The United States and Iran are engaged in ceasefire negotiations, but key disputes including the nuclear issue and the Strait of Hormuz remain unresolved. With international oil prices continuing to soar amid the effects of the Strait of Hormuz blockade, inflationary pressure on the real economy has become unavoidable.
By contrast, the shock to the economy appears more limited than initially feared at the onset of the war. Downside risks for Korea are expected to be sufficiently offset by export growth driven by the semiconductor super-cycle, the government's expansionary fiscal stance, a large-scale supplementary budget, buoyant asset markets, and a rise in inbound foreign tourists. First-quarter gross domestic product (GDP) significantly exceeded expectations, and this year's growth rate is expected to reach the mid-2 percent range or higher.
Overseas central banks are also tilting toward tightening. The Reserve Bank of Australia (RBA) delivered its third consecutive rate hike at its May meeting. The Bank of Japan (BOJ) and the European Central Bank (ECB) held rates steady in April but are expected to raise them at their June meetings. The Bank of England (BOE) and the Bank of Canada (BOC) face relatively heavier economic burdens, but since the onset of the Middle East war, the perception has spread that price stability matters more than growth.
The BOK is also signaling a shift in policy stance. At the April Monetary Policy Board meeting, the BOK maintained its position that it would carefully assess the impact of the Middle East war, but more recently it has left the door open to action depending on the second-round effects of inflation and trends in core prices and inflation expectations. Notably, the BOK deputy governor last week made remarks hinting at a possible pivot toward rate hikes. The cited factors include a rise in crude oil import unit prices stemming from the prolonged Middle East war and the possibility that the consumer price index (CPI) will enter the 3 percent range starting in May. Stronger-than-expected first-quarter GDP also appears to have heightened the need to adjust market expectations.
Accordingly, the likelihood of a rate hike in the third quarter has risen further. Depending on the May Monetary Policy Board meeting, both July and August appear possible as timing for a hike. The Board's dot plot and dissenting opinions going forward will serve as key gauges. A July "insurance hike" or an August hike following a cautious intermediate step is anticipated. Signals on monetary policy could be delivered through the governor's speech at the BOK's founding anniversary in June. I expect a finely tuned monetary policy operation that, in line with Governor Shin Hyun-song's pursuit of "cautious and flexible" monetary policy, promotes price and financial stability while minimizing negative impacts on economic growth, vulnerable groups and financial markets.
