South Korea: Inflation and a hawkish BOK

South Korea’s CPI inflation has continued to surprise on the upside in the recent three months, surging from 4.1% YoY in March to 5.4% in May. This has exceeded the levels implied by our forecast model by a wide margin. Our model incorporates Brent crude oil prices, FAO food prices, industrial production, broad money supply M2, as well as inflation expectations under the consumer confidence survey. This model could explain 94% of the variance of actual CPI during the past two decades (2001-2021). Deviation between actual CPI and model-implied CPI is normally within the ±0.4ppt range. But this gap has widened sharply since March, to 1-2ppt. 

A closer look shows that the jump in CPI between March and May was led by food, followed by transport, housing & utilities, clothing & footwear, furnishing & household equipment and maintenance, and restaurants & hotels. Among food items, prices of meat and vegetables & seaweeds increased the most.

Indeed, imported food prices have been soaring in recent months. The Russia-Ukraine crisis has boosted global wheat prices. This, in turn, lifted animal feed costs and thus meat prices. But the rapid rise in South Korea’s food prices in the last three months has far exceeded that implied by FAO food price index and USD/KRW exchange rate. The supply chain strains in China (due to the recent Shanghai lockdown) and the US may have further added food shipping costs. The US contributes 27% of South Korea’s total food imports, including 43% in meat, 33% in dairy products, 29% in cereals, and 27% in vegetables & fruits. China also accounts for a significant 12% of South Korea’s food imports, including 21% in fish & seafood, and 29% in vegetable & fruits. Meanwhile, we also suspect that there is commodity price speculation in the local market. Farmers and retailers may want to take the opportunity of rising import costs to hike domestic prices, to make profits.

The Bank of Korea (BOK) has raised the benchmark repo rate by a cumulative 125bps since kickstarting the tightening cycle in August 2021, from 0.50% to 1.75%. In response to the faster-than-expected rise in inflation, the BOK accelerated the pace of tightening recently, delivering back-to-back 25bps rate hikes at the April and May meetings. Assuming Brent oil prices stabilise at USD110/barrel and FAO food prices also stabilise, our forecast model shows that CPI inflation will remain at the current high levels in 3Q. This will likely continue to prompt the BOK to hike rates consecutively at the July and August meetings, from 1.75% to 2.25%.  

We still think the BOK’s hawkishness will fade towards the end of this year (we now expect the benchmark repo rate to peak at 2.50% in 4Q). The model-implied CPI will ease slightly to about 3.5% by Dec22 and further to 2.5% by Dec23. Should the disruptive factors dissipate (supply chain pressure, China lockdown, price speculations), actual CPI could ease more notably than the model-implied CPI in 2023. Even if these factors remain in place and CPI numbers remain higher than forecasted, persistent monetary policy tightening would not be the best way to tackle these supply-side inflation problems, in our view.

Another reason dissuading the BOK from hiking rates further in 2023, in our view, is the rise in household debt repayment burdens. Every 25bps hike in the benchmark rate is estimated to increase the interest costs for the household sector by about KRW3tn (0.1% of GDP). The BOK’s 125bps hikes so far have boosted household debt repayment costs by an equivalent of 0.6% of GDP. If the benchmark rate is lifted further to 3.00%, the 250bps total hikes will boost household debt repayment costs by a significant 1% of GDP.

South Korea’s household sector is highly leveraged. According to the IIF’s latest statistics, South Korea’s household debt to GDP ratio stood at 104% in 1Q, the highest among 36 major economies it examined. As interest rates further go up, policymakers will likely pay closer attention to the adverse impact of higher rates on household financial conditions, banks’ credit risks, and overall financial stability.

Taiwan: Moderate inflation pressure and gradual policy normalisation

In Taiwan, inflation has not deviated much from our expectations so far this year. Headline CPI rose to 3.3% YoY in March and further to 3.4% in May, basically matching the estimates in our forecast model. Our model incorporates Brent oil prices, FAO food prices, base wage growth, money supply M2, and consumers’ inflation expectations. Taiwan’s CPI numbers are highly volatile, susceptible to the swings in vegetable and fruit prices during the typhoon seasons. These weather-related volatilities could not be easily captured by regression models. Thanks to stable weather conditions this year, our model well predicted the movement in actual CPI.

Taiwan’s central bank (CBC) has just kickstarted the tightening cycle in March, raising the benchmark discount rate by 25bps to 1.375%. We continue to expect the CBC to raise rates at the next seven policy meetings this and next year. Our model suggests that CPI numbers have peaked at around 3% in 2Q, and will fall to 2.5% by Dec22 and further to 1.7% by Dec23 (assuming oil and food prices both stabilise). Although inflation momentum will ease, inflation levels will remain above the historical 10-year average of 1% for some time, due to the pickup in wage growth and the increase in inflation expectations (we have revised up 2022 and 2023 inflation forecasts to 3.0% and 1.8%, compared to 2.3% and 1.2% previously). If policy rate stays at the current 1.375%, the inflation-adjusted real policy rate will remain in the negative territory this and next year, still fuelling concerns about asset prices inflation and financial imbalance. To address the negative real rates, the CBC would need to lift policy rate further towards the 2% level.

Having said that, we expect the CBC to reduce the magnitude of rate hikes to 12.5bps from the upcoming June meeting. This is because growth headwinds have increased. The disrupting impact of the recent China lockdowns on exports and manufacturing sector is bigger than expected. Taiwan’s export orders fell suddenly by -5.5% YoY in April, the first decline since February 2020. Manufacturing PMI also dropped to 50.0 in May, the lowest reading over two years.

Meanwhile, Taiwan’s domestic Omicron outbreak also weighs on consumption and services sector this quarter. Retail and recreation activities declined notably by about 15% between mid-April and end-May, as measured by the Google mobility data.

Beyond the short term, there are mounting concerns about a general global slowdown in 2023, in the aftermath of the supply-side inflation shock, monetary policy tightening, and geopolitical tensions. Taiwan is a small and open economy that is highly dependent on the global trade cycle especially the tech cycle. Exports of goods and services accounted for nearly 70% of its GDP in 2021. As global growth uncertainties increase, the CBC is likely to adopt a more careful approach on its pace of monetary policy normalisation, in the remainder of this year and 2023.

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