[Kim Sangchul's Economic Focus] Interest Rates Are Rising... Slowly and Cautiously

Concerns over Inflation Drive Global Rate Increases

Even with Trump's Pressure... 'Pause and Hike' Approach

The 'Debt Trap' Means Limited Scale and Speed

Bond Yields: The Wildcard Beyond Policy Rates

The recent developments in interest rate policies among major advanced economies have become increasingly noteworthy. In the United States, the 30-year Treasury yield surpassed 5% in mid-May, marking the first time since the 2007 global financial crisis. The 10-year Treasury yield is also at around 4.5%. Even Japan, once seen as the epitome of ultra-low interest rates, has seen its 30-year government bond yield enter the 4% range—the highest level since issuance began.

Federal Reserve (Fed) building in Washington D.C., USA. Photo by Reuters Yonhap News

The backdrop to this broad-based rise in interest rates among advanced economies is, as expected, concerns about inflation. Heightened tensions in the Middle East put upward pressure on international oil prices, which in turn fuels concerns about overall price increases. In April, the U.S. Personal Consumption Expenditures (PCE) price index rose by 3.8%, and core PCE increased by 3.3%, both hitting their highest levels in nearly three years. Widening fiscal deficits in major countries are also contributing factors to rising interest rates. When cash-strapped governments increase bond issuance, bond prices inevitably fall and yields rise. The rush to secure enormous funds for investments in artificial intelligence (AI) infrastructure is another reason for climbing bond yields.

As economic conditions shift, even the U.S. Federal Reserve (Fed), which was weighing a rate cut at the beginning of the year, has changed its tone. In April, there was a rare display of internal division as more members opposed holding rates steady. Although a new Fed chairperson, appointed by U.S. President Donald Trump and favoring rate cuts, has taken office, the market already seems to believe that lowering rates will not be easy. The situation is quite similar in Korea. While announcing a hold on the base rate, Shin Hyun-song, Governor of the Bank of Korea, indicated that although the rate was held this time, there may be a need to raise the base rate at an appropriate time in the future. Market rates have already surged, with the 10-year government bond yield exceeding 4% and the 3-year yield approaching 4%. The possibility of a shift in monetary policy stance is already reflected in interest rates. The era of low rates and abundant liquidity appears to be ending, and the world now seems to have no choice but to accept rising rates. Naturally, higher interest rates deal a blow to asset markets. When rates climb, the value of stocks and bonds, and even assets like Bitcoin and gold, tends to fall. Yet the more important issue is not the rise itself, but the magnitude and speed of rate increases. If rates are set to rise, just how far will they go?

In the past, once the Fed or the Bank of Korea set the direction of monetary policy toward rate hikes, the pace was rapid and the increases were large. The Fed, for instance, started raising its base rate from the 0% range in March 2022 and took it up to 5.25–5.50% by July 2023. The Bank of Korea also raised its rate quickly, from 1.25% in January 2022 to 3.5% in January 2023. However, to get straight to the point, there is little chance that a similar scenario will play out this time. The main brake on rapid rate hikes is the surge in debt. As of the first quarter, global debt reached $353 trillion, up from around $300 trillion in 2022. The ratio of global debt to GDP is now about 305%, just over three times the world’s total annual output. In March, the U.S. Congressional Budget Office warned that the U.S. national debt had surpassed $39 trillion for the first time, an increase of $9 trillion in just four years. The federal government now pays more than $1 trillion a year in interest, and if 10-year bond yields climb over 6%, annual interest payments will exceed $2 trillion. This would mean one-third of federal tax revenue would go solely to interest—a burden even the U.S. government could hardly bear. Korea faces similar constraints: household debt exceeding 2,000 trillion won and national debt at 1,300 trillion won are the biggest factors limiting the direction and pace of the Bank of Korea’s monetary policy.

Shin Hyun-song, Governor of the Bank of Korea, attended the Monetary Policy Committee plenary meeting held at the Bank of Korea in Jung-gu, Seoul on the 28th of last month and struck the gavel. [Photo by Yonhap News Agency Joint Reporters]

In fact, the quantitative easing (QE) policies adopted globally after the financial crisis were not solely aimed at stimulating the economy. Large-scale government bond purchases by central banks also served to lower long-term interest rates and reduce the financial burden on governments. The most convenient way to address public debt is to keep nominal GDP growth high while maintaining interest rates below that growth rate. A certain level of inflation can help increase nominal growth and ease the debt burden. Ideally, if strong growth, moderate inflation, and low interest rates are maintained, the debt-to-GDP ratio will naturally fall even if the absolute amount of debt does not decrease. Of course, if inflation expectations are not properly controlled, market interest rates can spike and the cost of rising rates may outweigh the benefits of nominal growth.

It is essential to maintain balance at an appropriate level. Some degree of inflation will have to be tolerated. While there may be no official acknowledgement, it is likely that inflation in the 3% range will be considered acceptable going forward. Taking into account the thresholds created by debt and the level of inflation, both the U.S. and Korea are likely to raise base rates, but at a slow and cautious pace. The Fed’s aggressive hikes of 0.5 or 0.75 percentage points at a time to tame inflation are practically impossible now. If rates are to rise, we are likely to see a 'Pause and Hike' strategy—small hikes followed by a period of observation, giving the market time to adjust. Assuming two hikes of 0.25 percentage points each, the Fed’s base rate would reach about 4.0–4.25% by the end of the year, and Korea’s would be around 3.0%. Any further rate increases would depend on inflation and economic conditions at that time. Unless inflation surges to threatening levels, it will be difficult for the total increase over the next year to exceed 1 percentage point.

One potential wildcard is the market interest rate. Regardless of the base rate, there is a possibility that market bond yields, especially long-term yields, could rise even further. While short-term rates are directly linked to the base rate set by central banks, long-term rates are influenced by the economy’s long-term growth prospect, future inflation expectations, and the scale of government bond issuance. In the U.S. in particular, the sheer volume of Treasury issuance can affect market rates as much as, or even more than, the Fed’s policy decisions. Even if the Fed refrains from raising rates due to pressure from President Trump, who favors cuts, an increase in long-term rates seems unavoidable.

Sangcheol Kim, Economic Commentator

This content was produced with the assistance of AI translation services.