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As the US has entered a rate hike cycle, there are growing concerns about the path of the Fed fund’s rate and its implications. Against this backdrop, this article analyzes the direction of US monetary policy and its risks, and explores how it would affect Korea’s financial market, especially market interest rates.

According to an analysis of US rate hike cycles since the 1970s, inflation tends to accelerate when the policy rate remains lower than the neutral rate of interest. This indicates that with the policy rate being around the neutral rate, it would be difficult to stabilize prices during the current rate hike cycle. Furthermore, even if the policy rate is pushed higher than the neutral rate, a much tighter monetary policy would be required considering the state of inflation at hand. In particular, given the late response of the Fed, unless inflation is curbed shortly by external drivers, the Fed is likely to lift interest rates well over the levels of the neutral rate. It will probably lead to the recurrence of monetary policy shocks.

If the Fed’s tightening is stronger than expected, it would transmit the shock to Korea’s financial market in the short run. The analysis has found that the Fed’s rate hike shock raises long end yields of Korea Treasury Bonds (KTBs) higher, influencing other market interest rates as well. Furthermore, it drives up the interest rates of corporate bonds and increases financing costs of banks, thereby pushing up the loan interest rate of households. 

On top of that, prolonged tightening by the Fed could trigger an inversion in short-term government bond yields as well as policy rates between Korea and US. However, given the propensity of foreign investors, the gap in interest rates between the two countries is unlikely to have a significant effect on the overall capital flows. But it is worth noting that if the Fed’s tightening is added to growing downside risks to growth, it could escalate adverse effects, which requires extra caution. 

The Fed’s tightening shock would aggravate the burden of financing on each economic player. This may require domestic policy responses, such as the purchase of KTBs and provision of liquidity, to cushion the blow. In addition, it is necessary to devise effective countermeasures by closely monitoring risks in the financial market and the possibility of such risks transmitting to the real economy.