Bank of Korea surprises with rate rise, eyes inflation

Saturday, 11 June 2011 00:00 - - {{hitsCtrl.values.hits}}

SEOUL (Reuters): South Korea’s Central Bank raised interest rates on Friday for the third time this year, surprising financial markets, as the government warned of rising inflation risks even as growth in Asia’s fourth-largest economy cools.

The Bank of Korea raised its benchmark rate by 25 basis points to 3.25 percent, playing down growing concerns about a slowing global economy that have persuaded three major central banks in Asia to hold rates steady this month.

It was the fourth time in six rate-setting meetings this year that the Bank of Korea had gone against the market consensus and its decision triggered a selloff in bond markets.

“I can’t understand today’s decision. There is a dearth of reasons to raise rates given that external jitters linger and inflation is stabilising,” said Lee Sung-Kwon, Chief Economist at Shinhan Investment.

Governor Kim Choong-soo, a close ally of President Lee Myung-bak and often regarded as a dove, shifted his language from concerns about bad loans at domestic savings banks and “cautious consideration” at the May rate meeting to focus on battling inflation at Friday’s meeting.

The decision to raise rates was unanimous in the six-member policy committee, Kim said.

“We have to pay attention to core inflation in order to prevent high inflation from becoming chronic,” Kim told reporters, referring to the accelerating growth in prices of goods other than volatile fuels and foods.

Bond prices fell sharply on the central bank’s unexpectedly hawkish stance on inflation, with the shorter end hit harder, as investors rushed to price in a more aggressive policy tightening in the coming months.

The benchmark 5-year treasury bond yield rose 6 basis points to 3.91 percent while Seoul shares turned lower from early gains. The won briefly rose but later returned to previous levels, up 0.1 percent on the day against the dollar.

Although surprised by the sudden shift in Kim’s language, some economists said recent data was not evidence of the start of a prolonged economic slump and noted that at current levels, the Bank of Korea’s monetary policy stance remained “accommodative”.

“At the global level, I read current data weakness as evidence of a soft patch, not a turn in the cycle. Hence, inflationary pressures are unlikely to go away if interest rates remain at accommodative levels, that is, below 4.0-4.5 percent,” Hong Kong-based Erik Lueth at Royal Bank of Scotland said in a note to clients.

Governor Kim acknowledged external factors such as the euro zone’s debt problems and the political instability in the Middle East were a big risk.

Twelve out of the 20 analysts surveyed by Reuters had predicted the Bank of Korea would hold the policy rate steady after raising it by a total of 1 percentage points in four steps between July last year and March this year.

Soon before the rate decision was announced, Finance Minister Bahk Jae-wan warned a group of senior government foficials that inflation, which has consistently exceeded the Bank of Korea’s target range, would stay elevated for the time being.

Bahk took office early this month after the government received a drubbing in regional polls thanks to rising inflation and subdued wage growth.