South Korea & Taiwan: Inflation surprise and policy impact

We measure the inflation surprise in South Korea and Taiwan and assess the monetary policy outlook.
Group Research, Ma Tieying08 Jun 2022
  • South Korea’s inflation has beaten our forecast by a wide margin in the last three months
  • Inflation surprise will likely prompt the BOK to hike rates consecutively in July and August
  • Hawkishness may fade in 4Q as inflation eases and household debt concerns increase
  • Taiwan’s inflation has not deviated much from our forecast model
  • The CBC may hike only 12.5bps at the June meeting as growth headwinds increase
Photo credit: Unsplash Photo

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.

To read the full report, click here to Download the PDF


Ma Tieying 馬鐵英, CFA

Senior Economist - Japan, South Korea, & Taiwan 經濟學家 - 日本, 南韓及台灣

Subscribe here to receive our economics & macro strategy materials.
To unsubscribe, please click here.

The information herein is published by DBS Bank Ltd and/or DBS Bank (Hong Kong) Limited (each and/or collectively, the “Company”). This report is intended for “Accredited Investors” and “Institutional Investors” (defined under the Financial Advisers Act and Securities and Futures Act of Singapore, and their subsidiary legislation), as well as “Professional Investors” (defined under the Securities and Futures Ordinance of Hong Kong) only. It is based on information obtained from sources believed to be reliable, but the Company does not make any representation or warranty, express or implied, as to its accuracy, completeness, timeliness or correctness for any particular purpose. Opinions expressed are subject to change without notice. This research is prepared for general circulation.  Any recommendation contained herein does not have regard to the specific investment objectives, financial situation and the particular needs of any specific addressee. The information herein is published for the information of addressees only and is not to be taken in substitution for the exercise of judgement by addressees, who should obtain separate legal or financial advice. The Company, or any of its related companies or any individuals connected with the group accepts no liability for any direct, special, indirect, consequential, incidental damages or any other loss or damages of any kind arising from any use of the information herein (including any error, omission or misstatement herein, negligent or otherwise) or further communication thereof, even if the Company or any other person has been advised of the possibility thereof. The information herein is not to be construed as an offer or a solicitation of an offer to buy or sell any securities, futures, options or other financial instruments or to provide any investment advice or services. The Company and its associates, their directors, officers and/or employees may have positions or other interests in, and may effect transactions in securities mentioned herein and may also perform or seek to perform broking, investment banking and other banking or financial services for these companies.  The information herein is not directed to, or intended for distribution to or use by, any person or entity that is a citizen or resident of or located in any locality, state, country, or other jurisdiction (including but not limited to citizens or residents of the United States of America) where such distribution, publication, availability or use would be contrary to law or regulation.  The information is not an offer to sell or the solicitation of an offer to buy any security in any jurisdiction (including but not limited to the United States of America) where such an offer or solicitation would be contrary to law or regulation.

This report is distributed in Singapore by DBS Bank Ltd (Company Regn. No. 196800306E) which is Exempt Financial Advisers as defined in the Financial Advisers Act and regulated by the Monetary Authority of Singapore. DBS Bank Ltd may distribute reports produced by its respective foreign entities, affiliates or other foreign research houses pursuant to an arrangement under Regulation 32C of the Financial Advisers Regulations. Singapore recipients should contact DBS Bank Ltd at 65-6878-8888 for matters arising from, or in connection with the report.

DBS Bank Ltd., 12 Marina Boulevard, Marina Bay Financial Centre Tower 3, Singapore 018982. Tel: 65-6878-8888. Company Registration No. 196800306E. 

DBS Bank Ltd., Hong Kong Branch, a company incorporated in Singapore with limited liability.  18th Floor, The Center, 99 Queen’s Road Central, Central, Hong Kong SAR.

DBS Bank (Hong Kong) Limited, a company incorporated in Hong Kong with limited liability.  13th Floor One Island East, 18 Westlands Road, Quarry Bay, Hong Kong SAR

Virtual currencies are highly speculative digital "virtual commodities", and are not currencies. It is not a financial product approved by the Taiwan Financial Supervisory Commission, and the safeguards of the existing investor protection regime does not apply.  The prices of virtual currencies may fluctuate greatly, and the investment risk is high. Before engaging in such transactions, the investor should carefully assess the risks, and seek its own independent advice.