The Bank of Korea unexpectedly raised the benchmark interest rate by a quarter percentage point to a three-year high of 4.25 per cent on Thursday, in a pre-emptive move to stem inflation despite growing concerns that economic growth may slow down in the second half.
It was the fourth rise in the overnight call rate since October, reflecting the central bank?s confidence that growth in Asia?s fourth-largest economy would not be hampered by higher oil prices and the stronger won.
South Korea?s gross domestic product grew 6.1 per cent in the first quarter, the fastest annual growth in more than three years, propelled by strong exports and a consumption recovery. The BoK has forecast 2006 economic growth at 5 per cent compared with 4 per cent last year.
?The economy is still on an upward momentum with stable inflation. But inflationary pressure is building due to higher oil prices and the continued economic recovery,? said Lee Seong-tae, the BoK governor.
The country?s core inflation, which excludes volatile food and fuel prices, has stayed below the BoK?s target range as the stronger won helps cushion the impact of higher oil prices on the world?s fifth-largest oil importer. But it jumped to a 10-month high of 2.0 per cent in May and is expected to accelerate in the second half.
Mr Lee hinted the BoK may tighten the monetary policy further if the economic recovery gathers pace, because the 4.25 per cent call rate was still supportive of economic growth.
?The moves of the two key constraints ? the stronger won and higher oil price ? have stabilised this month, allowing the BoK to raise interest rates,? said Lim Ji-won, an economist at JPMorgan. ?The interest rate is approaching a neutral level but I don?t think the tightening cycle is over now.?
Thursday?s rate rise helped push the benchmark Kospi index 3.45 per cent lower, the biggest daily percentage drop in two years. Markets across Asia all fell heavily.
Meanwhile, the International Monetary Fund painted a rosy outlook for the South Korean economy on Thursday, renewing its forecast for economic growth of 5.5 per cent this year, half a point higher than the government's projection.
?I think the economy is in much better shape than people are willing to give it credit for,? Joshua Felman of the IMF told the Financial Times after two weeks of discussions with Korean government and business officials, adding that economic data had been ?encouraging?.
?Export growth has been very, very strong, consumption continues to grow at the same rapid pace as earlier this year, and imports of capital equipment grew by 30 per cent year-on-year in May, which is probably a sign that fixed investment is picking up,? he said.
Mr Felman played down the risks the strong won and high oil prices presented to the South Korean economy, saying exports were more sensitive to global demand than exchange rates. ?Of course there are risks but they're not such big risks that we've been convinced to reduce our growth forecast,? he said.
To ensure the long-term health of the economy, the IMF advised Seoul to deregulate the service sector and encourage credit card companies to persuade consumers to spend more discriminately.
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