Bank of Korea raises rates to 3.25%

No one can accuse Korea's central bank of being overly predictable. So it proved today when, contrary to market expectations, officials raised rates to 3.25%. Soggy data in the rest of the world did little to sway officials, with the vote being unanimous. And rightly so: shortly after the decision, China announced bumper import numbers, suggesting that Korea's most important trade partner is still going strong. Apart from inflation, Korea are also tweaking rates up to discourage consumers from borrowing. These twin motivations for tightening will stay in place over the second half. Expect more hikes.

Sure, markets were taken by surprise. But, as we argued in Keepin' it real last 3 June 2011, there was always a strong case for a hike, even if economic data had turned weaker in the last couple of months. First: inflation. Yes, the headline reading rolled over and, at 4.1% y-o-y in May, stands barely above the central bank's target range of 2-4%. By August, headline inflation should be back where it belongs. But the trouble lies with core, which has continued to trend up, jumping from 3.2% to 3.5% and should drift up further in the coming months.

In the press conference today, Governor Kim warned that the central bank needs to prevent high inflation from becoming "chronic". Apart from rising core price pressures, this was also a reference to elevated inflation expectations as measured by consumer sentiment surveys.

Unless these come down sharply, expect another rate hike in the third quarter. In fact, the Governor himself emphasized today that "interest rates are the most important factor affecting long-term inflation expectations".This underlines that the expected near-term drop in headline inflation may not be sufficient for the Bank of Korea to stop tightening.

Second: household debt. Real interest rates are in barely positive territory.Thus, there is a strong case to push ahead with rate hikes to dissuade consumers from taking out even more loans. While the Governor emphasized that microeconomic tools are the best way to address this, the overall macroeconomicsetting clearly matters as well. The Bank of Korea, therefore, will likely maintain a tightening bias regardless of the near-term inflation outlook until the policy rate hits at least neutral, which we estimate around 4.2%.

Third: growth. Lots of chatter in markets lately that the global economy has hit the skids. Friday's painful non-farm payroll number in the US clearly didn't help and neither did slumping export growth in cyclically sensitive places like Taiwan. Indeed, there are signs that the global inventory adjustment that we have highlighted for some time now may have a little further torun. But, the case for a global hard landing appears misplaced. Growth is slowing, not crashing.

The Governor himself noted that private consumption and capital investment appears to have rebounded in May and hinted that the Bank of Korea hadmore data on hand than financial markets to make that assessment. In fact,following the BoK's decision today, China released bumper import numbers that should go a long way to easing concerns that Asia's growth engine has suddenly run dry.