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EDRisk of low interest rate

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Monetary easing should be economic stimulus of last resort

The Bank of Korea kept its policy rate unchanged at 1.25 percent Friday, drawing attention to the direction of its monetary policy. Some analysts predict the central bank will continue to freeze its base rate this year, citing somewhat improved economic indices and the need to keep pace with the government's efforts to stabilize housing prices. Others, however, expect a rate hike as early as next month if the economy remains in the doldrums.

Emerging from the Monetary Policy Board meeting, BOK Governor Lee Ju-yeol left open the possibilities for either freezing or lowering base rate, indicating the monetary authority will take different approaches depending on the economic situation at home and abroad as well as inflationary pressure. What is essential for the central bank is to use its interest rate policy as a means of last resort to stimulate the economy. If the BOK keeps lowering the rate recklessly to jump-start the economy, it will be unable to use the rate card when a real crisis hits the country. Even if the authorities have some room left for a further rate cut, they could fall into a "liquidity trap," which will make all other policy tools useless.

The International Monetary Fund has also warned against the risk of the low interest rate. "The policy to keep interest rates low has played an important role in pulling the global economy out of the worldwide financial crisis," it said. "Still, it is now emerging as the detonator of another crisis by increasing corporate debts and causing the tipping effect of risky assets." The surge in real estate prices in Korea is one such phenomenon.

A small open economy like Korea's may find it burdensome that a low interest rate increases the possibility of capital outflow. Korea's foreign reserves have exceeded $400 billion. However, it can ill afford to remain complacent. All this shows how the use of the base interest rate as an economic stimulus can backfire in various ways ― and why the central bank should err on the side of caution.





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