Interest rates are determined by market supply and demand, but the government adjusts the benchmark rate to regulate the economy. Why is this system in place? This article explains the difference between market interest rates and the benchmark rate, the government’s role, and how interest rates impact the economy in simple terms.
The Role of Market Interest Rates and the Benchmark Rate
In a capitalist society, prices fluctuate based on supply and demand. Interest rates can also vary based on demand and supply. If people seek the commodity of money in large quantities, the usage fee—the interest rate—rises. Conversely, if fewer people want to use money, demand decreases, causing interest rates to fall. The interest rate determined in the market based on the demand and supply of money is called the ‘market interest rate’.
If market interest rates are allowed to fluctuate freely, they can have a tremendous impact on the entire economy. Imagine leaving a four-year-old child, full of energy, unsupervised inside a house. You can’t kick the child out just because they’ve turned the house upside down. The parents who left the child alone bear greater responsibility. Similarly, each country’s government must fulfill the duty of appropriately controlling and managing interest rates, which are like that four-year-old child. A primary method of control is setting a ‘benchmark interest rate’.
The benchmark interest rate that regulates the pace of the economy
The benchmark interest rate is set by each country’s central bank; in Korea’s case, it is set by the ‘Bank of Korea’. Market interest rates are determined by adding various additional rates, including the bank’s profit margin, to the benchmark rate. If we liken the flow of the economy to a car, market interest rates are the speed at which the car travels, and the benchmark interest rate is the accelerator and brakes that regulate the car’s speed. The Bank of Korea holds the steering wheel of this car. The public is the passenger in the back seat. Passengers demand the driver arrive safely and on time at the destination. Therefore, the driver must not recklessly speed out of a desire to reach the destination quickly (high-speed economic growth), nor should they stubbornly insist on a snail’s pace (populism lacking growth) while chanting “safety first.”
To grasp basic economic principles, it’s good to understand at least the U.S. central bank. Why the U.S. central bank specifically? Because the U.S. is the center of the global economy. It means the U.S. is the pivotal nation controlling the world’s ‘flow of money’. This is evident simply from the fact that the U.S. currency, the dollar, serves as the ‘reserve currency’. We’ll revisit reserve currencies when discussing exchange rates.
The institution serving as the central bank in the United States is called the ‘Federal Reserve System’. Therefore, while in Korea the Governor of the Bank of Korea, who chairs the Monetary Policy Committee, announces the base rate, in the US it is announced by the Chair of the Federal Reserve Board.
As previously illustrated using the car analogy, the economy’s safety and speed must be balanced. Going too fast or too slow causes problems. Lowering the base rate is like the driver pressing the accelerator. When the base rate falls, market interest rates follow suit. Since the cost of using money becomes cheaper, it becomes easier to spend. Consequently, consumption and investment increase. As demand rises, supply must also increase. Companies produce more and expand factories. They also need to hire more people, increasing household income. Ultimately, the overall economy improves.
Base Rate ↓ ⇨ Market Rates ↓ ⇨ Consumption ↑ / Investment ↑ ⇨ Production↑ / Employment↑ ⇨ Economic Upturn
Conversely, raising the base rate is like hitting the brakes. When the base rate rises, market rates also increase. People find it harder to spend money, consumption and investment shrink, and corporate profits decline. Companies reduce production and cut staff. Unemployment rises and the economy worsens.
Base Rate↑ ⇨ Market Rates↑ ⇨ Consumption↓ / Investment↓ ⇨ Production↓ / Employment↓ ⇨ Economic Slowdown
When news reports mention lowering or raising the base rate, it allows us to predict the overall economic trend. News about a base rate hike signals that consumption should be reduced, and above all, borrowing should be cut back. Instead, savings should be increased, so prepare your ammunition (cash).
Since late 2021, as the U.S. has continued its rapid interest rate hikes, terms like ‘Big step’ and ‘Giant step’ have become widely used. Typically, the base rate moves in increments of 0.25 percentage points, referred to as a ‘step’. When rates rise by 0.5 percentage points—double a standard step—it’s called a ‘big step’. A 0.75 percentage point hike (triple a step) is a ‘giant step’. A 1.0 percentage point increase is termed an ‘ultra step’ (though no such ultra step has occurred yet). Understanding these terms allows you to immediately grasp what headlines like the example mean and how much the interest rate is rising.
Today, the world is interconnected. In this environment, changes in the U.S. benchmark interest rate inevitably impact the Korean economy. The global economy is more complex, but let’s simplify it for now. When the U.S. base rate rises, investing in the U.S. yields higher interest. Think of it like depositing money in a U.S. bank. With higher interest, more people invest in the U.S. Investors who were putting money into Korea withdraw those funds and invest in the U.S. Instead, fewer investors put money into Korea, causing Korean corporate stock prices to fall. This leads to a slowdown in the Korean economy.
To prevent this scenario, Korea can raise its base rate when the U.S. does. Typically, Korea’s benchmark interest rate is higher than America’s. However, exceptions exist. Very rarely, when America’s benchmark rate is higher than Korea’s, this situation is termed an ‘interest rate inversion’. When monitoring interest rates, one must watch America’s rates as well, not just Korea’s.
The Bank of Korea’s Special Mission: Regulate the Flow of Money!
The Bank of Korea sets the benchmark interest rate to regulate the overall economy; this is called ‘monetary policy’. Money refers to the flow of funds, and the money supply is the amount of money circulating in the market. In other words, monetary policy involves increasing or decreasing the amount of money circulating within the market (my pocket, corporate pockets, government pockets). Since the central bank plays a crucial role in the national economy, it must not be manipulated at the whim of the government. Therefore, the Bank of Korea operates independently. Currently located near Sungnyemun Gate in Seoul, it does not accept deposits from the general public. Nevertheless, it bears the name ‘bank’ because it is the institution managing the lifeblood of the Korean economy—the flow of money.
What level of economic activity is appropriate to target? The goal of monetary policy is precisely ‘price stability’. Generally, when the consumer price inflation rate is maintained around 2%, prices are considered stable (the target figure is continually adjusted according to the prevailing economic conditions). The appropriate price level is determined in consultation with the government. This highlights that while the Bank of Korea operates independently, it cannot be completely separated from the government.
This blog post will not delve into the specific tools the Bank of Korea uses to adjust the base rate. If you’re eager to explore more complex topics, try searching for terms like ‘reserve requirement ratio’, ‘open market operations’, or ‘rediscount rate’. Knowing these terms can be helpful, but not knowing them won’t significantly impact your daily life.
What’s the difference between quantitative easing, quantitative tightening, and monetary policy?
The terms ‘quantitative easing’ and ‘quantitative tightening’ frequently appear in economic news. Quantitative easing means increasing the amount of money in circulation, while quantitative tightening refers to the opposite.
Earlier, we discussed how the central bank controls the money supply through the base rate. So why are quantitative easing or quantitative tightening necessary? This concept stems from global economic downturns. During an economic slump, the Governor of the Bank of Korea can implement the following monetary policy:
Economic Slump ⇨ Base Rate ↓ ⇨ Consumption ↑ / Investment ↑ ⇨ Production ↑ / Employment ↑ ⇨ Economic Recovery
However, problems arise when attempting to lower the benchmark interest rate. Reducing the benchmark rate presupposes that ‘there is something left to lower’. If the benchmark rate is already 0%, there is nothing further to reduce. While some countries implement negative interest rates, most do not.
How can the cost of using money be lowered when the benchmark rate cannot be reduced any further? It becomes clear when considering the supply and demand perspective. To lower prices, increase supply. It’s only natural that when there’s more money, the cost of using it becomes cheaper.
Monetary policy sets the target value of the base rate and indirectly increases or decreases the money supply through various steps. Simply put, it encourages people to take out money they were holding onto or to put back money they were about to take out. Quantitative easing, on the other hand, involves the government directly injecting new money into the market. As the name implies, it involves easing (increasing) the money supply quantitatively.
Quantitative easing is achieved by the government issuing government bonds or purchasing financial assets. This is often referred to as “printing money.” Of course, this approach comes with side effects. Issuing government bonds means the government incurs debt, and purchasing financial assets also means the government spends money. Therefore, the longer quantitative easing continues, the more the government’s debt increases. To prevent the country from collapsing, quantitative easing must be reduced. Stopping quantitative easing and withdrawing money is called quantitative tightening. The method involves moving in the opposite direction of quantitative easing, such as halting the purchase of financial assets.
