This blog post examines how benchmark interest rate hikes impact consumption, investment, economic trends, and inflation, calmly assessing how effective interest rates actually are as a tool for economic stability and price management.
Why does the Bank of Korea adjust the base rate?
When you make a deposit or open a savings account, interest accumulates, allowing your money to grow. Conversely, when you borrow money through a mortgage, you must pay interest. The types of interest rates applied when borrowing and lending money are diverse, and interest rates can fluctuate depending on the situation. Notably, most interest rates have risen significantly since 2022. As a result, those who borrowed money at variable rates faced considerable hardship due to the increased interest burden.
Why did interest rates rise? The reasons are diverse, too numerous to explain with a single cause. They can vary based on the demand and supply of funds, differ depending on an individual’s credit rating or the presence of collateral, and show different movements depending on the gap between short-term and long-term rates. However, the primary cause of the interest rate increases seen since 2022 is the central bank raising its benchmark interest rate.
The benchmark interest rate is set by the central bank. In South Korea, the Bank of Korea holds eight Monetary Policy Committee meetings annually to announce whether it will lower, raise, or freeze the benchmark rate. The United States also adjusts its benchmark interest rate through its central bank. When the benchmark rate rises, other interest rates generally increase as well; conversely, when the benchmark rate falls, other rates tend to decrease across the board. So why does the central bank adjust the benchmark rate?
As mentioned earlier, GDP is crucial. A decline in GDP negatively impacts citizens’ livelihoods, so governments and central banks fundamentally act to boost GDP. When facing a recession or economic crisis where GDP declines in the short term, the common-sense and fundamental responses fall into two main categories. One is for the government to spend more money, and the other is for the central bank to lower the benchmark interest rate. Recall the earlier explanation that GDP, from the expenditure side, is divided into household consumption, government spending, and business investment.
Fiscal Policy and Monetary Policy
When the economy slows, consumer sentiment weakens, production activity declines, and incomes shrink. As a result, the recession can easily spiral into a vicious cycle of further intensification. At this point, if the government intervenes by spending money to directly purchase goods, distributing cash to citizens, or lowering taxes to stimulate consumption, it can be expected to have a stimulating effect on the economy. This is called ‘fiscal policy’ or ‘expansionary fiscal policy’.
Next is the role of the central bank. When the central bank lowers the benchmark interest rate, market interest rates generally decline. This makes it easier for companies to invest for the future. Corporate investment typically involves borrowing money to start new ventures or expand existing ones, then repaying the borrowed funds with subsequent profits. Therefore, high interest rates make business expansion difficult due to the interest burden, but when interest rates fall, the reduced interest burden tends to increase investment.
The same applies to individuals, or households. When interest rates fall, people tend to reduce savings and increase consumption. When individuals earn income, they generally have two main choices: consumption, or spending money, and saving. Low interest rates create a psychological inclination to borrow money to consume, whereas high interest rates make borrowing feel burdensome. Furthermore, when interest rates are high, even regular savings deposits at banks accumulate a decent amount of interest. However, when interest rates are low, even making regular savings deposits doesn’t significantly increase the interest earned. For these reasons, a decrease in interest rates also has the effect of stimulating consumption.
Anticipating these effects, the central bank’s policy of lowering the base interest rate is called ‘monetary policy’. There is a common saying that ‘consumption is a virtue’.
This expression implies that when the economy worsens, the biggest problem for businesses is unsold goods. Therefore, if individuals or the government actively purchase goods to prop up the economy, businesses gradually recover, leading to a revival of the entire economy.
So, does using fiscal or monetary policy solve all problems when the economy is weak? Theoretically, employing such policies during recessions or economic crises is valid. However, if the economy is already trending toward appropriate growth, these policies may prove ineffective or even cause adverse effects.
Fiscal policy involves government spending. But governments cannot spend money indefinitely. The fundamental principle is to manage finances during normal times to respond to crises, using reserves when necessary. Excessive spending risks diminishing the capacity to act when it truly matters, requiring prudence. The same applies to monetary policy. Lowering interest rates when the economy isn’t in recession increases the likelihood that funds will flow primarily into asset markets like real estate or stocks, rather than stimulating real economic activity. This carries risks such as sharp asset price increases.
Furthermore, even when economic conditions appear poor, it’s difficult to distinguish whether it’s a temporary downturn or a phase of low growth where the trend itself is weakening. Fiscal or monetary policy can be somewhat effective during a short-term downturn, but their efficacy significantly diminishes in a prolonged low-growth phase. When the long-term trend deteriorates, more enduring policies are needed: improving economic fundamentals, implementing structural reforms, investing in key industries, and further, investing in education and science and technology. Furthermore, while consumption can help during a short-term downturn, in the long run, increasing savings to create an environment where companies can more easily secure funds from banks may be more beneficial for the overall economy.
The problem is that when the economy worsens, it is difficult to immediately determine whether it is a recession or a deepening process of low growth. While the two situations can be relatively clearly distinguished after time has passed, interpretations inevitably vary among people at the present moment. This leads to various debates among scholars and politicians. Therefore, a more detailed diagnosis is necessary, and policy decisions must also be approached with caution and care.
The Sudden Variable: Inflation
There is another crucial variable here: inflation. Inflation is not just the rise in the price of a specific good, but a phenomenon where the prices of various goods and services increase across the board. To assess this, a price index is calculated, and the rate of increase is used to gauge the level of inflation.
While we previously explained that central banks regulate the economy through interest rates, their more crucial role is actually preventing inflation from becoming excessive. The central bank’s primary objective is to manage the value of money stably. If inflation worsens and commodity prices fluctuate frequently, uncertainty across all economic activities increases, and citizens’ livelihoods become more difficult.
Therefore, the central bank bears the responsibility of curbing inflation, and the primary tool it employs for this purpose is raising interest rates.
For the past roughly 30 years, relatively low inflation was maintained, making it relatively straightforward to determine interest rates based on indicators like GDP growth rate or unemployment rate. However, in 2022, inflation intensified sharply worldwide, making inflation management the most urgent task. As a result, the U.S. benchmark interest rate has risen rapidly since 2022, bringing an end to the prolonged era of low interest rates and ushering in a period of high rates. During this process, South Korea also significantly raised its benchmark interest rate, with the impact felt across households and businesses.
Since the 2008 global financial crisis, the central bank’s primary concern had been how to further stimulate the economy while maintaining low interest rates. However, the situation changed starting in 2022. Central banks’ focus shifted back to raising interest rates to curb inflation, placing the benchmark rate at the center of this shift. In this context, the benchmark rate can be understood not merely as a number, but as a signal that encapsulates the economic situation and policy judgment.
