SOUTH KOREA'S RUNAWAY INFLATION!

South Korea's central bank unexpectedly raised its key interest rate to the highest in nearly eight years to curb runaway inflation. Fueling concerns about the future of the world's 13th-biggest economy, which is already sliding due to lethargic private consumption and high energy import costs as well as huge household debt that could jeopardize lenders.

The Bank of Korea increased the benchmark seven-day repurchase agreement rate to 5.25 percent from 5.0 percent, the first since August 2007, and its highest since early February 2001.

The central bank said that spiraling inflation, which is the fastest in a decade and caused by soaring fuel and commodity prices, has posed a great challenge to the South Korean economy.

In a press conference, BOK Governor Lee Seong-tae said the rate hike was aimed at getting inflation under control. "It's a common saying that the longer high inflation lasts, the bigger the risk the economy will face," he said. Another bank official described rising inflation as "the largest risk to the South Korean economy since the 1997-87 financial crisis."

South Korea's annual inflation accelerated to 5.9 percent in July, the fastest past in 10 years, squeezing household incomes and corporate profits. The country's annual inflation jumped to 5.5 percent in June, also surpassing the central bank's target range of 2.5 to 3.5 percent.

The central bank hinted at a further rate hike sooner or later as it expected prices to keep rising in coming months. "Consumer prices are expected to remain high for a considerable time given lingering fallout from higher oil prices and a possible gain in public utility charges," the bank’s statement said.

Lee vowed to place the top priority on containing inflation, saying it is not yet time for monetary policy to focus on economic growth because the inflation risk remains in place. "We see more risks of inflationary pressure than those of economic slowdown," he said.

But the challenge seems difficult to be addressed because inflation is not of domestic origin, driven by a global surge in oil and raw material prices, which the government can do little to control.

South Korea, the world's fifth-largest oil importer and second-biggest gas buyer, is vulnerable to international price rises because it buys almost all of its energy and raw materials needs from overseas.

Additional rate increases unlikely

Many economists said additional rate increases are unlikely, citing greater downside risks with weakening domestic demand and a slowing global economy.

"Today's rate hike seems as a preemptive measure to cope with inflationary pressure," said Koh Yoo-son, an economist at Daewoo Securities. She ruled out a further rate increase, forecasting consumer to stabilize in the fourth quarter on the back of recent drops in oil prices.

Koh and other economists warn tough anti-inflation measures would backfire, by suppressing the investment and consumption that generate growth, which threatens to put the brakes on the country's economic expansion at a time when domestic demand is rapidly declining.

The country's private consumption dipped 0.1 percent in the second quarter from the previous three months, marking the first quarterly minus growth in four years, according to the central said. In the first quarter, private consumption gained 0.4 from the previous three months.

Analysts also said the rate hike is expected to increase interest payment burdens for households and smaller companies, which could eventually damage health of local lenders.

The country's household debt rose to a record last year as consumers borrowed to buy houses and spent more on credit cards, according to the central bank report. Household credit, the sum of household loans and credit card installments, climbed to 630.7 trillion won (US$ 621.4 billion) at the end of last year from 582 trillion won a year earlier.

Slowing growth and soaring inflation

Due to the slowing private demand, the South Korean economy grew at an annual rate of 4.8 percent in the second quarter, down from 5.8 percent for the previous quarter.

The Asian Development Bank has recently trimmed its forecast for South Korea's economic growth to 4.7 percent for this year from 5.0 percent set three months ago, far below President Lee Myung-bak's earlier promise of a 7-percent growth.

Economists say the combination of slowing growth and soaring inflation would boost the risk of stagflation – a combination of stagnation and high prices.

Finance Minister Kang Man-soo recently expressed concerns that the economy seems to be moving toward a phase of stagflation and was in its worst trouble since the Asian financial crisis.