Market participants are reassessing the monetary policy path for South Korea, driven by inflationary pressures from oil price shocks linked to the Middle East conflict and robust economic growth underpinned by the memory chip upcycle amid the AI infrastructure construction wave. As expectations for a Bank of Korea (BOK) interest rate hike intensify, the yield on the 10-year Korean government bond rose 11 basis points to 4.06% on Tuesday, breaking above the 4% threshold for the first time since late 2023. The BOK is scheduled to hold its policy meeting on May 28, with markets keenly focused on the interest rate signals it may provide.
Several major financial institutions are revising their expectations for BOK monetary tightening. For instance, Goldman Sachs now forecasts two 25-basis-point rate hikes in the third and fourth quarters of this year, a shift from its previous projection of no rate changes in 2024. Hana Securities also predicts one rate hike this year, having previously anticipated no change. Park Junwoo, a fixed-income strategist at Hana Securities, noted, "South Korea is facing a scenario where rising oil prices mechanically push up inflation, while at the same time, the semiconductor supercycle is driving upward revisions to growth expectations."
Mirae Asset Global Investments stated last month that the massive wealth generated by Korean chipmakers will boost spending and inflation, prompting the BOK to implement at least three rate hikes over the next year. Choi Jinyoung, Managing Director and Head of Fixed Income at the firm, suggested that employee bonuses at chip companies, elevated chip prices, and a booming stock market are likely to exacerbate price pressures, potentially pushing the policy rate from the current 2.5% to a peak of 3.5% by the second half of 2027. Choi also indicated that the background of the new BOK Governor, Shin Hyun Song, could influence policy direction. Governor Shin, who will chair his first monetary policy meeting on May 28, has extensive experience in international finance and policy-making. "He has long focused on exchange rate volatility and is more likely than his predecessor to factor the won's exchange rate into interest rate decisions," Choi added.
This shift overturns the previous market consensus for policy stability in South Korea this year. Investors are increasingly concerned that the AI-driven boom will sustain stronger-than-expected economic growth—evident in first-quarter data—while high energy prices further stoke inflation. South Korea's heavy reliance on imported oil makes it particularly vulnerable to oil price shocks.
In contrast, Nomura Holdings expects the BOK to keep rates unchanged until next year (implying no hike in 2024) but anticipates the central bank will signal a more hawkish stance in its dot plot. Economists at Nomura, including Jeong Woo Park, wrote in a report that accelerating overall inflation gives the BOK stronger grounds to send hawkish signals, as this relates to inflation expectations and household perceptions of price increases. Notably, the impending departure of Shin Sung Hwan, a prominent "dove" on the BOK's monetary policy board, is tilting the committee toward a more hawkish stance ahead of the May 28 meeting.
South Korea's Finance Minister, Koo Yun-cheol, appeared to lay the groundwork for potential BOK rate hikes in remarks on Monday. He stated that he expects the country's economic growth rate to exceed 2% this year, supported by a surge in global semiconductor demand. He specifically highlighted "inflation and the real estate market as direct risk factors" and noted these are priority issues for the government to address.
**Middle East Tensions Intensify South Korea's Inflation Pressure** Since late February, when the U.S. and Israel launched attacks on Iran, leading to Iran's blockade of the Strait of Hormuz—a critical chokepoint for global energy transportation—international oil prices have surged significantly. This poses a substantial burden for South Korea, which is highly dependent on imported oil. South Korea relies heavily on energy imports, with approximately 70% of its oil and 20% of its liquefied natural gas sourced from the Middle East, most of which transits through the Strait of Hormuz. The ongoing disruption to shipping through the strait has pressured South Korea's energy supply, driving up gasoline and diesel prices and tightening supplies of raw materials like naphtha and urea, impacting the broader economy.
The energy shock has compelled the South Korean government to adopt increasingly stringent measures, including setting fuel price ceilings to protect the economy. Authorities have also stated they will formulate contingency plans to curb energy demand and stabilize prices. Against this backdrop, South Korea's Consumer Price Index (CPI) rose 2.6% year-on-year in April, a significant jump from 2.2% in March, marking the largest year-on-year increase since July 2024. Petroleum product prices surged 21.9% year-on-year, the highest increase since the Russia-Ukraine war.
More critically, a channel for the self-fulfillment of inflation expectations is opening. The one-year inflation expectation for April rose to 2.9%, up 0.2 percentage points from March, now just a step away from the 3% warning threshold. The Livelihood Price Index increased 2.9% year-on-year in April, indicating that the price increases most frequently perceived by residents in their daily lives have now exceeded the overall CPI. For every 1 percentage point increase in this perceived inflation, inflation expectations are pulled up by 0.66 percentage points—precisely the "expectations spiral" path the BOK is most vigilant about.
Several major banks have already raised their inflation forecasts for South Korea. JPMorgan Chase significantly increased its 2026 inflation forecast from 1.7% to 2.7%, while DBS Bank and Bank of America Merrill Lynch raised their forecasts to 2.6% and 2.9%, respectively. The average inflation forecast from 38 institutions at the end of April had risen to 2.5%. According to analyses by international investment banks and related institutions, if Middle East tensions persist and international energy prices rise further, South Korea's inflation rate could breach the 3% level between May and September.
The BOK has explicitly stated that, influenced by oil prices, it expects CPI to begin accelerating from April. BOK Senior Deputy Governor Ryoo Sang-dai previously issued a rare hawkish signal, stating it is "time to consider stopping rate cuts and possibly even raising rates." Ryoo noted that while the Middle East conflict adds uncertainty to the economic outlook, domestic price increases have already exceeded previous expectations, and the semiconductor cycle is significantly stronger than market forecasts. He further indicated that the BOK "could" signal a rate hike within this year or at some future point during its May 28 rate decision meeting.
**"K-Shaped Economy" Increases Probability of Rate Hikes** In the first quarter of 2026, South Korea's real GDP grew 1.7% quarter-on-quarter, not only rebounding from the -0.2% contraction in the fourth quarter of last year but also marking the highest growth rate in five and a half years since the third quarter of 2020—nearly double the BOK's own February forecast of 0.9%. However, a breakdown of this growth reveals an extremely uneven structure. According to a BOK report, excluding the IT manufacturing sector centered on semiconductors, the economic growth rate would be directly reduced by approximately 0.4 percentage points. This is a precise depiction of South Korea's "K-shaped economy."
Former BOK Governor Lee Chang-yong stated frankly at a press conference following the February rate meeting that the three major factors driving the current economic divergence are the IT industry-led growth structure, rapidly rising asset prices, and the faster-than-expected leap in AI technology. The latest forecast from Citigroup economists points out that, driven by the global AI capital expenditure cycle, South Korea's chip exports could surge by 56% for the full year 2026, a significant acceleration from the 23% growth in 2025, potentially directly lifting annual GDP growth by 1.3 percentage points.
An outlook report released by the Export-Import Bank of Korea on May 3 also indicated that second-quarter exports are expected to surge 30% year-on-year to approximately $230 billion. However, at the same time, the decoupling between export items is intensifying—semiconductors are climbing steadily, while non-IT goods like petrochemical products continue to slow.
This economic structural divergence is forcing the BOK into a difficult choice. In the view of Goldman Sachs, South Korea's "K-shaped economy" necessitates rate hikes. The core logic can be summarized as "balance of payments-driven rate hikes"—the siphoning effect of chip exports creates a massive trade surplus and currency appreciation pressure, while inflation provides auxiliary confirmation on the other end. The "K-shaped economy" plays a unique role in this logic—it makes rate cuts unfeasible while increasing the acceptability of rate hikes.
A team led by Goldman Sachs economist Andrew Tilton wrote in a report: "AI-related exports could triple this year, reaching nearly 30% of GDP. Meanwhile, non-tech exports will remain subdued due to regional oversupply and energy shocks." "The K-shaped economic structure suggests that targeted, prudent fiscal policy should be adopted. With AI-driven exports surging, the won should appreciate."
Beyond high inflation, another reality is that a consensus has formed among senior BOK officials that the won is excessively undervalued. This is essentially a policy signal—the central bank believes the current exchange rate level has deviated from fundamentals, and interest rates are the most direct tool to correct undervaluation. Maintaining a low interest rate differential would keep pressure on the won, while initiating rate hikes could recalibrate the exchange rate. Under these constraints, a rate hike shifts from an option to a direction.
Former Governor Lee Chang-yong explicitly stated: "Interest rates are not the appropriate tool to address this K-shaped recovery problem. This issue should be tackled through fiscal policy and other institutional reforms." The implication is that monetary policy has been relieved of its mission to "fix the K-shaped imbalance" and should focus solely on its primary mandates—inflation and exchange rate stability. The main purpose of a rate hike would be to defend the won's exchange rate and curb inflation, which are crucial for macroeconomic stability.
ING economists summarized the situation—if GDP growth far exceeds potential levels and inflation expectations rise further, the BOK will focus on its inflation target and enter a rate hike channel in the second half of 2026.
Market pricing on Monday clearly reflected expectations for BOK rate hikes. Interest rate prediction models show that the market-implied call rate as of August 8 has risen to 2.834%, implying approximately 1.5 rate hikes from the current benchmark rate of 2.50%. The market interprets this as a high probability that the BOK will initiate a rate hike in July. A bond manager at an asset management company stated: "May price data is expected to surge further; the central bank's pressure is already 'like a fire singeing the eyebrows.' Barring any major unexpected events, a July rate hike is highly likely."