Fed cut narrows rate gap, bringing Korea modest relief

The US central bank’s rate cut has offered South Korea some breathing room by narrowing the policy rate gap between the two countries. Given the persistent dollar demand weighing on the local currency, however, the won's upside potential may remain constrained.

The US Federal Reserve lowered the benchmark federal funds rate by a quarter point to between 3.5 and 3.75 percent, in line with market expectations.

With the Bank of Korea holding its rate at 2.5 percent since May, the Fed's 0.25 percentage point rate cut reduced the policy rate differential between Korea and the US to as much as 1.25 percent, bringing it to the lowest level since February 2023.

For Korea, a widened rate gap with the US typically raises concerns over capital outflows as funds tend to seek higher yields, placing downward pressure on the won. A narrowed differential helps ease such outflow pressures, tempering the won’s depreciation against the dollar.

The Fed's rate cut gives the BOK more room to exercise its monetary policy, considering Korea's central bank has cited volatility in the foreign exchange market as a factor for keeping the base rate steady.

Yet, with the recent depreciation of the Korean won largely driven by the heavy dollar demand, the effects of the narrowed rate gap may be limited for the time being.

For instance, the won’s value hovered around a 1,300 per dollar range in August, when the Korea-US rate gap stood at its highest of 2 percentage points. Though the rate differential was narrowed to 1.5 percentage points in October, the won's value further tumbled to as much as 1,480 per dollar in the following weeks.

According to forex authorities, the recent weakness in the won stems largely from the surging dollar demand, influenced by increased overseas investments by retail and institutional investors, including the National Pension Service, as well as Korean companies’ growing preference to hold on to their dollar earnings, instead of converting them into the won.

Bank of Korea Gov. Rhee Chang-yong said the recent devaluation of the won “is not due to the Korea-US rate differential, but simply because overseas equity investment has increased” after the BOK’s rate-setting meeting in November.

Underscoring the latest dynamics, the Korean won remained sluggish against the dollar Thursday, though the greenback extended losses against major peers, including the euro, Swiss franc and Japanese yen, following the rate decision.

The won closed daytime trading at 1,473 per dollar, losing 2.6 won from the previous session. After opening the session with a slight gain, the won soon reversed course and weakened throughout the day.

“In addition to cutting rates, the Fed’s announcement of short-term Treasury purchases has further boosted risk-on sentiment. But dollar-buying demand stemming from residents’ overseas equity investments and importers’ payment needs continues to weigh down on the won’s valuation,” Woori Bank economist Min Kyung-won said.

The local stock market surged in the early hours, showing a dovish reaction to the Fed's rate decision, but it turned weak during afternoon trading.

The benchmark Kospi closed at 4,110.62, losing 24.38 points, or 0.59 percent, from the previous session.

The index opened at 4,163.32 and surged to a peak of 4,170.77 during intraday trading, but it later turned to a loss.

Retail investors and foreign investors net bought 408.2 billion won and 347.2 billion won ($277.6 million and $236 million), respectively, while institutional investors offloaded 776.1 billion won.

The secondary Kosdaq closed at 934.64, shedding 0.36 points or 0.04 percent. During intraday trading, it touched a 2025 high of 943.19, but later turned sluggish.