The Bank of Korea raises interest rates for the first time in three and a half years: the policy shift is driven by the AI chip boom, officially beginning a tightening cycle.

On July 16, the Bank of Korea raised its policy rate by 25 basis points to 2.75% from 2.50%, marking the first rate hike since January 2023, in line with market expectations. This move signifies the official end of the four consecutive rate cuts cycle since the end of 2024, and marks the beginning of a new tightening cycle. Following the rate hike decision, the South Korean stock market experienced severe volatility. As of the time of writing, the South Korean KOSPI composite index plummeted by over 6%, a 26% drop from its historical high in June, officially entering a bear market. Blue chip stocks were sold off across the board - SK Hynix fell over 11% and Samsung Electronics dropped over 8%. The "sell the news" trend in the semiconductor sector and the direct impact of the rate hike on leveraged stock market investments overlaid, triggering a sharp market correction. AI chip frenzy reshapes the fundamentals of the South Korean economy The root cause of this rate hike lies in a structural economic transformation driven by artificial intelligence. Economic growth has far exceeded expectations, with the South Korean government raising its GDP growth forecast for 2026 from 2.0% at the beginning of the year to 3.0% on July 14. If achieved, this would be the fastest growth rate since 2021. The nominal GDP growth rate is expected to reach 12.3%, the highest in 30 years since 1996. The International Monetary Fund had previously raised its growth forecast for South Korea in 2026 to 2.6%, the highest increase among 30 major economies. Export data is also astonishing. South Korea's exports surged by 71% year-on-year in June, exceeding $100 billion in exports, setting a historical record. In the first five months of 2026, South Korea's current account surplus reached $141.3 billion, surpassing the historical high of $123.1 billion for the entire year in 2025, indicating that the annual surplus target has been achieved by more than halfway. The Bank of Korea expects exports in 2026 to grow by 40% year-on-year, and the current account surplus to reach a record $290 billion. The Bank of Korea clearly stated that this chip cycle is different from the past. In a report submitted to Parliament, the central bank said that the current expansionary cycle, which began in March 2023, has lasted for 40 months, far exceeding the historical average of 29 months for five expansion cycles between 2000 and 2020. The fundamental DRIVE comes from the competitive investments made by global tech companies to adapt to the ecological transformation of the AI industry, rather than traditional cyclical demand. The Bank of Korea emphasized that massive investments in AI infrastructure have significantly boosted semiconductor demand, but the pace of supply expansion remains slow, and there is no sign of easing the supply-demand imbalance. Competitive investments by global tech companies, coupled with supply constraints on advanced chips like HBM, are expected to sustain this growth momentum for a considerable period of time. Exports in June, adjusted for working days, grew by 59.5% year-on-year, while chip shipments surged by 199.5%. Since taking charge of the first policy meeting in May, Governor Shen Hyun-sung has repeatedly emphasized that inflation, economic growth, exchange rates, and financial stability risks all point in the same direction - towards a rate hike. He made a rare explicit statement after the May meeting that "it is necessary to raise interest rates at the appropriate time." Three major pressures drive the rate hike Persistent high inflation is the most direct catalyst. South Korea's consumer price index rose by 3.2% year-on-year in June, the fastest pace since December 2023, surpassing 3% for the second consecutive month. The core CPI remained at 2.5%, indicating that underlying price pressures remain stubborn. The surge in prices of gasoline and diesel, driven by the US joint action against Iran, is the main driver - gasoline and diesel prices soared by 23% and 34% respectively year-on-year. The government expects the average inflation rate for 2026 to be 2.6%, far exceeding the central bank's target of 2%. The continued weakness of the Korean won has intensified imported inflation pressure. The Korean won has depreciated by about 4% so far this year, and the exchange rate against the US dollar in June hit its lowest level since 2009. Policy makers have repeatedly cited currency weakness as an additional reason for tightening monetary policy. Financial stability risks cannot be ignored either. Apartment prices in Seoul have risen for 75 consecutive weeks, and household debt has accelerated again. According to data submitted by the Bank of Korea to Parliament, if the interest rate is raised by 25 basis points, the annual interest burden for borrowers of housing-related loans will increase by 1.8 trillion Korean won. The central bank's latest Financial Stability Report explicitly states that it will raise interest rates at the "appropriate time" to curb these risks. Tightening cycle begins, market focuses on the path ahead This rate hike marks the beginning of a new tightening cycle. Most economists expect the Bank of Korea to raise rates again before the end of 2026, with the interest rate potentially rising to 3.0%, and some forecasts even go as high as 3.25%. The dot plot released in May shows that most members of the council expect the policy rate to reach 3% in the next six months. Citi expects the Bank of Korea to maintain a pace of raising rates by 25 basis points each quarter in the second half of 2026 - once in July and once in October, with the possibility of further hikes in January and April 2027. Jemin Choi, an economist at Hyundai Motor Securities, expects the central bank to maintain a hawkish stance, but given that risks related to inflation, currency, and the Middle East conflict have not significantly worsened, it is more likely to maintain the current stance rather than shift further towards a more hawkish stance. Lim Jae-kyun, a fixed income analyst at KB Securities, pointed out that while oil prices remain high, the second-round inflation effects have not yet materialized, and factors such as slowing wage growth and recent strength of the Korean won may lead the central bank to avoid consecutive rate hikes at the next meeting on August 27. The rate hike decision coincides with Federal Reserve Chair Jerome Powell's semiannual testimony to Congress this week. Powell on Wednesday refuted the view that the surge in AI investments could exacerbate inflation, believing that this frenzy may not necessarily lead to sustained price pressures. The Fed's latest semi-annual monetary policy report also noted that although the construction of AI infrastructure has created price pressures in the near term, the impact may be limited. In a press conference, Shen Hyun-sung may be asked to respond to Powell's comments. The Bank of Korea faces a delicate balance: monetary policy needs to work in concert with macroprudential policy to prevent financial imbalances while avoiding stifling investment vitality in the AI field. The current recovery of the South Korean economy remains structurally unbalanced - the divergence between exports and domestic demand is worth noting. Household debt continues to rise, core city housing prices continue to climb, while at the same time, the growth dividend from the booming semiconductor exports is spreading from the manufacturing sector to the service industry, wages, and asset price areas. As economist Jemin Choi of Hyundai Securities said, "It is expected that the Bank of Korea will maintain a hawkish stance and retain the possibility of further tightening of monetary policy. However, given that risks related to inflation, currency, and the Middle East conflict have not significantly worsened, they are more likely to maintain their current stance rather than shift to a more hawkish one." When the triple pressure of higher-than-expected growth, the spreading pressure of inflation, and rising risks to financial stability converge, the Bank of Korea has no choice. The rate hike on July 16 is both a passive response of the South Korean economy to the AI frenzy, and a difficult balancing act between mitigating financial bubbles and safeguarding the investment vitality in AI. For South Korea, how Governor Shen Hyun-sung assesses the higher-than-expected growth, the spread of inflation pressures, and the rising risks to financial stability at the press conference on Thursday will be crucial for the market to judge the pace of subsequent tightening. The rate hike has arrived, but the end point of the tightening cycle remains far from clear.