Eyes on South Korea's new inflation target

The Bank of Korea held rates steady at 1.50% yesterday in a unanimous vote. The tone in the policy statement was slightly less confident than in the previous month, with a phrase added saying that "the improvement in economic agents' sentiments has been inadequate". During the post-meeting media briefing, the governor mentioned that the BOK will incorporate the further drop in oil prices into its inflation forecast during the economic outlook update next month. He also said explicitly that the Fed's tightening won't immediately lead to rate increases by the BOK. These comments induced some downward pressures on the short-term rates in the swap market yesterday, and weakened the KRW. 

Market focus next week will shift to the BOK's announcement of a new inflation target, in addition to the FOMC meeting. The BOK is expected tol set inflation target in a lower range of 2-3% for the 2016-2018 period, compared to 2.5-3.5% for the past three years. The actual inflation averaged just about 1% in 2013-2015, undershooting the official target by a wide margin. Inflation expectations have also come down. In the household sector, the expected inflation rate for the next one year has fallen to 2.5% in 2015, down from 2.8% in 2014 and 3.0% in 2013. 

The persistence of a negative output gap, labor market slack, and sluggish commodity prices have depressed the pricing power of both retailers and exporters and will likely continue doing so in 2016. Moreover, there are structural factors containing inflation and inflation expectations, such as the decline in transaction costs as a result of technological advancement and infrastructure improvement, and the fall in currency volatility thanks to stronger external positions and higher sovereign credit ratings. 

A lower inflation target, combined with a slower potential GDP growth, will mean a decline in "neutral interest rates". If a revision in inflation target is confirmed next week, it could reinforce the expectations that the benchmark rate will stay low for a long time and it won't return to the pre-2008 norm of 4% anytime soon. This should help to contain a rise in the medium- to long-term KRW bond yields, notwithstanding the pressure from the Fed's possible policy changes next week.