South Korea's inflation outlook still benign

South Korea's inflation numbers seemed to have bottomed out. Headline CPI registered 0.9% (YoY) in Oct15, a modest rise compared to 0.7% on average in 3Q15 and the highest rate seen since Nov14. Core CPI also picked up to 2.3% from 2.1%, the highest over eight months. 

The pricing power of retailors and downstream producers has improved, thanks to the recovery in domestic demand and a narrowing output gap. Under the CPI, prices of services items have started to rise notably since 3Q15, led by the subcomponents including housing, transport and catering. Externally, the deflation pressures from commodity price declines are also dissipating. The collapse in global oil prices occurred in 4Q14. Barring further shocks, the decline in oil prices is expected to narrow on the year-on-year basis from 4Q15 onwards.

Admittedly, the present inflation level remains very low compared to the tenyear average of 3%. Public inflation expectations are also moderate as revealed by the consumer confidence survey (latest: 2.5%). The cyclical force on inflation is turning positive. But structural factors, such as technological innovation and decreasing volatility in the KRW exchange rates, will likely continue to keep inflation and inflation expectations at bay. Consensus forecast is for headline CPI to rise to 1.7% in 2016 and 2.1% in 2017, still below the Bank of Korea's target range of 2.5%-3.5%. Expectations are also running high that the BOK will revise down its inflation target for the next three years, which will be announced by Dec15. 

Implications: the short-term KTB yields may face upward pressures as inflation bottoms out and additional BOK rate cuts become unlikely. But a benign inflation outlook, together with lingering uncertainties on the growth prospects, is expected to contain the rise in medium- to long-term yields.