The Bank of Korea (BOK), South Korea' s central bank, on Wednesday decided to lower its inflation target by one percentage point to 2 percent for the next three years, raising worry about a sharp decline in inflation target that may lead to troubles in achieving the goal amid volatile oil prices.
The current inflation target band of 2.5-3.5 percent, which is scheduled to mature at the end of this year, will be replaced by a point target of 2 percent for three years from next year, according to the Bank of Korea (BOK).
The fresh target is in line with the country's underlying inflation, defined by the bank as an inflation that excludes temporary shocks from supply-side inflationary pressure like a surge in oil prices as well as business cycle factors such as the global financial crisis. South Korea's underlying inflation hovered around 2 percent since 2012.
The 2 percent target is almost the same as an optimal inflation for the economy, which the BOK described as the most desirable inflation for the country's stable and sustainable growth. The steep downgrade in inflation target, however, was mainly attributable to a prolonged drop in crude oil prices.
"The recent drop in oil prices is putting downward pressure. (South Korea's) inflation is forecast to move toward 2 percent in the second half of next year," BOK Deputy Governor Suh Young Kyung told a press conference.
PROBABLE TROUBLES
Suh's comments indicated the BOK's tolerance for failing to achieve the inflation target of 2 percent by the end of next year given the downward oil import costs. Prices for West Texas Intermediate (WTI) tumbled 45.9 percent last year and declined more than 20 percent this year, according to the Korea Center for International Finance (KCIF).
Competition between the United States seeking a shale gas boom and major oil-exporting countries led by Saudi Arabia refusing to reduce production resulted in cheaper oil and bolstered expectations for further falls. Goldman Sachs even estimated global oil prices below 30 U.S. dollars per barrel in 2016 amid the continued glut.
Even more worse for the BOK would be the situation where oil prices turn upward sharply on unexpected factors, like political determination by the United States or oil exporters to remove the glut. Lessons can be learned from the BOK's monetary policy response in 2012.
Then BOK Governor Kim Choong-soo refrained from lowering the policy rate for 12 months to June 2012 despite concerns over the European fiscal crisis. At the time, pressures to cut rates were strong although oil prices stayed above 100 dollars per barrel.
Belatedly, the central bank cut borrowing costs by 25 basis points in July and October each in the year, shrugging off concerns over high oil prices as a supply-side factor. The complete opposite of it can be seen. If oil prices go up next year on resolved conflicts between the United States and oil exporters, the BOK would face much stronger pressures to raise interest rates rapidly amid the sharply lowered inflation target of 2 percent.
Of course, the bank could defy such demand, regarding high oil prices as a supply-side factor. Probability for higher oil prices seems low now, but cannot be ruled out given extreme volatility in oil prices seen since 2008. Global oil prices surged closer to 150 dollars in July 2008 and dropped to 32 dollars five months later. The prices rebounded since then, but posted a double-digit decline in 2014 and 2015.
ACCOUNTABILITY
To achieve the inflation target, the BOK plans to bear heavier accountability than before by explaining more about inflation situations when the consumer price inflation misses the target. If the headline inflation stays 0.5 percentage points below or above the target rate of 2 percent for more than six months, BOK Governor Lee Ju-yeol will be required to hold a press conference to detail the reasons of the missed target, inflation outlook and policy direction, the BOK said.
The continued missing of the target would force the BOK chief to hold another press conference for explanations every three months. "A heavier accountability for explanations will help stabilize inflation expectations by showing (the bank's) strong willingness to achieve the target," said Suh.
South Korea's consumer prices added 1 percent in November from a year earlier, escaping from the zero headline inflation for the first time in a year. Inflation expectations posted 2.5 percent last month.
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