2.8% inflation rate looms in Korea for 2014

Still a dull growth outlook.

According to DBS, the Bank of Korea kept the policy rate unchanged at 2.75% as expected last Friday, but downgraded the growth and inflation forecasts. The 2013 GDP forecast was lowered by 0.4ppt to 2.8% from 3.2%, while the inflation forecast was cut by 0.2ppt to 2.5% from 2.7%.

Growth is expected to recover to 3.8% in 2014, and inflation is projected to rise to 2.8% next year.

The BOK’s 2013 growth projection is now significantly lower than the private sector’s consensus of 3.2%, and far below the actual growth of 4% achieved on average in the
past decade.

Given a lackluster growth outlook, market expectations for a near-term rate cut remain alive. The 2-year bond yield continued to hover around 2.75%, a same level as the benchmark 7-day repo rate.

Here's more from DBS:

In our view, the chance of a rate cut in 1H13 is still lower than 50%. As the official growth forecasts are very conservative, the possibility of seeing upside surprise to
forecasts would be higher than the possibility of downside disappointment in the coming months.

Note that the trade and PMI data across the Asia region have started to improve, and the US data held up better than expected. In the domestic economy, property transactions have also risen from the bottom, thanks to the stimulus impact of the two rate cuts delivered in 2H12.

Meanwhile, we don’t think the upcoming new government (to take power in February) will exert political pressures on the BOK to cut rates. The policy priority of the new government is to narrow the income gap, reduce social inequality, improve household welfare and assist SMEs. The best means to achieve these goals are fiscal transfer and fiscal reforms.

Despite the rate cut talk, the Korean won continued to perform well, with the USD/KRW rate breaking the level of 1060 last Friday. The ongoing appreciation of the won is on the back of the improvement in Korea’s economic fundamentals - recovering growth, a strong current account surplus and falling external debt, as well as the revival in global risk appetite. It is doubtful whether cutting rates can have lasting impact on the won.

The central bank governor said last Friday that “the BOK doesn’t set interest rate policy only based on the won exchange rate”. He also said that the BOK will focus on managing won volatility via “smoothing operation”.