Morgan Stanley: South Korea's Central Bank Expected to Turn Hawkish in May, with Potential First Rate Hike in October

The Bank of Korea is set to hold a monetary policy meeting on May 28th. This is not only the first interest rate decision and policy press conference presided over by the new governor, Shin Hyun-son, but also a key window for assessing the shift of South Korea's macroeconomic policies towards tightening.

Strong economy generates a signal to pivot, rate may remain unchanged in May

Given the robust growth of South Korea's GDP in the first quarter and significant changes in the macro environment, Morgan Stanley expects the Bank of Korea to significantly upgrade its macroeconomic forecasts at the May meeting. Despite the consideration for smooth communication, it is expected that the May meeting will unanimously decide to maintain the current benchmark interest rate of 2.50%, but the prelude to policy tightening has officially begun.

Morgan Stanley forecasts that the new dot plot introduced by the central bank will release a clear bias towards tightening. The bank believes that the four rate cuts to 2.25% previously released by the Bank of Korea will be completely eliminated, replaced by six to nine policy dots supporting an increase to 2.75%, implying that the central bank internally has inclined towards the first interest rate hike within the next six months.

Macro forecasts全面提升，GDP expectations raised to 2%

The Bank of Korea had forecast a GDP growth rate of 2.0% for 2026 and a CPI inflation rate of 2.2% in February of this year. Supported by strong Q1 data and recent improvements in high-frequency indicators, Morgan Stanley expects the central bank to raise this year's GDP growth forecast directly to a mid-high level of 2.6% to 2.7%, while CPI inflation forecasts are also raised to levels around the mid-2% range.

Supporting this optimistic view is the better-than-expected performance of chip exports and the recovery of domestic demand. The central bank's previous forecast for export growth this year was only a cautious 2.1%, while the current Bloomberg-calculated market consensus has soared to 7.1%. In addition, the central bank's expectation for consumer spending growth this year is also expected to increase from 1.7% to above 2.0%, providing a basis for removing the easing bias.

For market investors, this means that the expectation of rate cuts has completely shattered, and the policy cycle has officially shifted gears. Morgan Stanley expects that after the Bank of Korea completes the initial communication of its macro stance in May, the policy meeting in July will show a clearer hawkish stance. The first rate hike is expected to land in October this year, followed by a pace of one rate hike per quarter. By the second quarter of 2027, the terminal interest rate of this tightening cycle is expected to reach 3.25%. Investors need to adjust their pricing models for the South Korean bond and foreign exchange markets in advance to cope with the upcoming rise in borrowing costs.

Next focus: Oil price assumption correction and secondary inflation risk

Since the previous forecasts did not fully incorporate the subsequent outbreak of conflicts in the Middle East, this meeting requires close attention to three major forecast adjustments. The first is the new governor's revision of oil price assumptions, which directly reflects the central bank's tone on the evolution of geopolitical situations. Currently, Morgan Stanley expects international oil prices to moderately fall to $90 per barrel by the end of the year, and to $80 next year.

Secondly, the market needs to closely track whether a second round of inflationary effects will occur in the third quarter as supply chain transmission to the service industry. Governor Sin Hyun-son's previous academic and theoretical framework is more inclined to see through the initial inflationary shock caused by the supply side, so any change in his attitude due to the emergence of comprehensive inflation risks driven by demand needs to be observed.

Finally, the repair process of weak domestic demand sectors in South Korea's K-shaped economic recovery will ultimately determine the pace and overall duration of this rate hike cycle.