What Happens When the Base Interest Rate Rises: The Impact on Inflation, Loans, Real Estate, and Consumption

What Is the Base Rate?

The base rate is the policy rate used by a country’s central bank as a benchmark for conducting monetary policy. In South Korea, the Monetary Policy Committee of the Bank of Korea sets the base rate after comprehensively considering factors such as inflation, economic conditions, and financial market conditions.

The benchmark interest rate is not merely a number used among banks. When the benchmark interest rate changes, it successively affects short-term market rates, long-term market rates, deposit rates, loan rates, bond yields, asset prices, exchange rates, and consumption and investment decisions. Therefore, a hike in the benchmark interest rate impacts everything from individuals’ loan interest rates and corporate investment costs to real estate buying sentiment and inflation trends.

Why Does the Entire Economy Feel the Impact When the Base Rate Rises?

The key purpose of a base rate hike is to raise the cost of borrowing and increase the incentive to hold or save money. When interest rates rise, the interest you must pay on the same loan amount increases; conversely, the interest income you can earn by placing money in deposits or safe assets increases.

These changes are transmitted to the economy in the following sequence:

1. The central bank raises the benchmark interest rate.
2. Market interest rates, such as interbank rates and bond yields, come under upward pressure.
3. Banks’ deposit and loan rates rise.
4. Households tend to reduce consumption and increase savings.
5. Businesses become more cautious about borrowing and investing.
6. As aggregate demand slows, inflationary pressure may ease.
7. Asset prices—such as real estate, stocks, and bonds—are revalued.

Summary of the Main Effects of a Benchmark Interest Rate Hike

1. How Will Inflation Be Affected?

A benchmark interest rate hike is not a “button” that directly lowers inflation. More precisely, it is a policy tool designed to reduce inflationary pressures.

When interest rates rise, people are more likely to choose saving over spending. Even those planning to take out loans to purchase cars, home appliances, homes, or business equipment may postpone their decisions due to the interest burden. Companies may also reduce inventory buildup or capital expenditures.

As a result, when aggregate demand in the economy declines, it becomes difficult for companies to raise prices at will. Furthermore, a signal from the central bank that it is raising interest rates is interpreted as a “commitment to controlling inflation,” which can lower inflation expectations. Lower inflation expectations can also influence corporate pricing decisions and wage negotiations.

However, in the following cases, prices may not fall immediately even if interest rates rise:

• When international oil prices or commodity prices surge
• When import prices rise due to an appreciating exchange rate
• When supply shrinks due to war, logistics disruptions, or climate issues
• When cost factors have a greater impact than demand, such as with public utility rates or food prices
• When the effects of interest rate hikes have not yet fully filtered through to the real economy

Therefore, while the statement “When the benchmark interest rate rises, prices fall” is useful for explaining the general direction, it is more accurate to view it in the real economy as “pressure to lower the inflation rate is created.”

2. Why Does the Burden on Borrowers Increase?

One of the areas where the impact of a benchmark interest rate hike is felt most quickly is in loans. When the benchmark interest rate rises, banks’ funding costs and market interest rates increase, which can be reflected in the interest rates on mortgages, personal loans, jeonse (lump-sum deposit) loans, and corporate loans.

In particular, for variable-rate loans, monthly payments may increase because changes in the benchmark or market interest rates are reflected in the loan’s interest rate after a certain time lag. Even with the same principal amount, higher interest rates mean higher monthly interest payments.

For example, households with large mortgage balances can see a significant increase in their annual interest burden even if the interest rate rises by just 1 percentage point. In such cases, households tend to cut back on discretionary spending—such as dining out, travel, and purchases of durable goods—which in turn can lead to a slowdown in domestic demand.

3. Why Do Depositors Benefit?

While interest rate hikes place a burden on borrowers, they can lead to increased interest income for depositors. When bank deposit rates rise, the interest earned on the same amount of money deposited increases.

For this reason, during periods of rising interest rates, relatively safe products such as deposits, savings accounts, short-term bonds, and money market funds may become more attractive than risky assets. However, not everyone actually benefits when deposit interest rates rise. If the inflation rate exceeds the deposit interest rate, the real rate of return—measured in terms of purchasing power—may be low or even negative.

4. Why Are Real Estate Prices Under Downward Pressure?

Real estate is an asset heavily reliant on borrowing. Many people do not purchase a home using only their own funds but also take out a mortgage. When the benchmark interest rate rises and loan rates increase, the monthly principal and interest payments for the same home become higher.

In this situation, buyers tend to take the following actions:

• Postpone their home purchase.
• Look for homes at lower prices.
• They reduce the size of their loan.
• They extend their stay in jeonse or monthly rental housing.
• They reduce real estate purchases for investment purposes.

When demand decreases, sellers may have to lower prices or relax transaction terms. Therefore, interest rate hikes generally put downward pressure on real estate prices.

However, real estate prices are not determined by interest rates alone. Regional supply, population migration, income levels, jeonse prices, taxes, lending regulations, redevelopment policies, positive development factors, and the lease system all play a role. Therefore, a rise in the benchmark interest rate does not necessarily cause home prices to fall by the same amount in every region.

5. What Impact Will This Have on Businesses and Jobs?

Companies borrow money to expand factories, fund research and development, carry out mergers and acquisitions, build inventory, and secure working capital. When interest rates rise, companies’ financing costs increase, and the profitability of new investments decreases.

For example, for a company to invest in new production facilities, the expected rate of return must be sufficiently higher than the borrowing rate. When interest rates rise, even investments that previously appeared profitable may become less attractive. If companies reduce their investments, sales, employment, and wage growth in related industries may also slow down.

In particular, companies with high debt ratios or weak cash flows face greater pressure during periods of rising interest rates. Conversely, companies with large cash reserves and strong pricing power may be relatively less affected.

6. How Will Financial Assets Such as Stocks and Bonds Be Affected?

Rising interest rates typically weigh on the stock market for two reasons.

First, companies’ interest expenses increase, which can reduce their profits. Second, the discount rate that investors use to calculate the present value of future corporate earnings rises. When the discount rate rises, the valuations of growth stocks may be particularly affected.

In the bond market, rising interest rates can lead to a decline in the prices of existing bonds. This is because newly issued bonds offer higher interest rates, making existing bonds with lower yields less attractive.

However, financial markets always move in anticipation of future events. Even if the benchmark interest rate actually rises, the reaction in asset prices may be limited if the market has already anticipated this for a long time. Conversely, a larger-than-expected rate hike or an unexpected signal of monetary tightening can increase market volatility.

7. How Will the Exchange Rate Change?

Generally, when a country’s interest rates are relatively high, the appeal of that country’s currency may increase. This is because foreign investors may seek to purchase assets denominated in that currency in anticipation of higher returns. In this case, the value of the won may rise, and the exchange rate may come under downward pressure.

However, the exchange rate is not determined by interest rates alone. U.S. interest rates, a strong dollar, the trade balance, geopolitical risks, foreign investment flows, and the domestic economic outlook all play a role. Therefore, there may be situations where the won weakens even after a hike in South Korea’s benchmark interest rate.

Advantages and Side Effects of a Policy Rate Hike

While a policy rate hike may be a necessary measure to stabilize prices, it also comes with side effects.

Advantages

• It can cool overheated consumption and investment.
• It helps lower inflation expectations.
• It can slow the pace of debt accumulation.
• It provides higher interest income to depositors and cash holders.
• It can alleviate overheating in asset markets.

Drawbacks

• The interest burden on borrowers increases.
• Consumption and investment may contract.
• Asset prices, such as real estate and stocks, may undergo a correction.
• The risk of default may rise for highly indebted households and businesses.
• It may lead to an economic slowdown and a decline in employment.

Why the Effects of Interest Rate Hikes Are Not Immediate

Changes in the benchmark interest rate are transmitted to the economy with a time lag. It takes time for bank lending rates to adjust, and households and businesses also need time to change their consumption and investment plans. It may take even longer for these changes to be reflected in inflation statistics.

Furthermore, economic actors look not only at current interest rate levels but also at their future direction. Even if interest rates are already high, a strong expectation that they will soon fall may limit the contraction in consumption and investment. Conversely, if there is a strong expectation that interest rates will remain high for a longer period, the tightening effect may be greater than the actual magnitude of the rate hike.

What Should Individuals Check?

During a period of rising interest rates, it is important to first review your cash flow and debt structure.

If You Have Loans

• Check whether your loan has a variable or fixed interest rate.
• Check the date of your next interest rate adjustment.
• Calculate how much your monthly payment might increase.
• Start by reviewing high-interest debt, such as personal loans, credit card loans, and overdraft accounts.
• Set aside an emergency fund to cover expenses even if your income decreases.

If You Have Deposits or Investments

• Compare deposit interest rates with the inflation rate.
• Distinguish between short-term funds and long-term investments.
• For bond-type products, check for price volatility resulting from interest rate changes.
• For stocks, consider both the company’s debt-to-equity ratio and cash flow.
• For real estate investments, review the loan interest rate, vacancy risk, taxes, and transaction volume.

Key Takeaways

When the benchmark interest rate rises, the cost of borrowing increases, and the appeal of saving money grows. As a result, consumption and investment tend to decline, and inflationary pressure may ease. Asset markets, such as real estate and stocks, are also affected by changes in borrowing costs and investor sentiment.

However, the effects of a benchmark interest rate hike are neither automatic nor straightforward. Inflation, real estate, exchange rates, the stock market, and economic trends are influenced not only by interest rates but also by supply shocks, government policies, overseas interest rates, market expectations, and income and employment conditions. Therefore, it is most accurate to understand a benchmark interest rate hike as a “powerful signal that alters the flow of money and decision-making across the entire economy.”