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The central bank focuses on wrong goal, KDI argues

It should be aiming for price stability rather than financial stability
Oct 29,2019
SEJONG - A state-run think tank advised the central bank to focus more on price stability and less on financial stability as the country gets perilously close to deflationary territory.

With the average monthly inflation rate through September at 0.4 percent, the Korea Development Institute (KDI) expressed alarm in a recent report, but it suggests a simple remedy.

“If the monetary policy prioritizes price stability, there wouldn’t be a high chance of deflation happening in the future,” said Jung Kyu-chul, a fellow at KDI, during a briefing at the Government Complex in Sejong.

Not only has Korea missed its official inflation target of 2 percent this year, consumer prices fell for the first time ever last month, by 0.4 percent, leading to concerns of deflation.

“Using short-term macroeconomic fiscal policies, it will be difficult to achieve stability in prices over the long term,” argued Jung. “Prices are ultimately determined by monetary policy.”

A cut in interest rates usually leads to an increase in money supply, resulting in higher inflation.

The think tank called for changes in how interest rate decisions are made so that the central bank can focus on price stability.

Current laws stipulate that the Bank of Korea also considers financial stability in implementing monetary policy. While the central bank had previously prioritized price levels, financial stability was introduced as a standard in 2011 after the global financial crisis.

The fellow said that the rules could lead to competing interests, adding that had the central bank prioritized price levels over financial stability, it would not have raised the benchmark interest rate in November last year.

“Although core inflation remained at around 1 percent for months and the economy showed signs of slowing, monetary authorities raised the interest rate to respond to household debt or financial stability,” said Jung, referring to the situation late last year.

The bank’s Monetary Policy Board said at the time that an increase was needed considering the rising levels of household debt.

Since the November increase, the central bank has cut the benchmark interest rate two times all the way down to a historic low of 1.25 percent. The central bank will make another rate decision next month.

Despite its warning, the think tank did not think that the country was already in deflation, explaining that temporary factors, such as a base effect from unusually high food and energy prices last year, contributed to the price fall last month. But concern remains.

“We shouldn’t just be wary of deflation but also low inflation,” said Jung, explaining that low inflation could cause a rise in real interest rates and weigh on investment and spending.

The fellow added that low inflation caused by supply factors is usually accompanied by high economic growth, explaining that recent sluggish growth indicates that low demand is also responsible for slowing price increases.

Jung also pointed out that Korea’s low inflation should not be seen as a sign of global economic downturn, noting that the country’s average monthly inflation rate this year is lower than those in the United States and Britain.

BY CHAE YUN-HWAN [chae.yunhwan@joongang.co.kr]