Inflation fell back to 2% range — so why is the Bank of Korea still on high alert?

South Korea's consumer price inflation eased back into the 2 percent range in July for the first time in three months, but the Bank of Korea is keeping its guard up. The reason: core inflation — the figure lurking behind the headline consumer price index — actually accelerated.

Core inflation strips out petroleum products and fresh food items such as agricultural, livestock and fishery products — categories whose prices swing sharply with oil prices and weather. By removing those volatile components, the measure captures the long-term, underlying trend in prices, which is why it is also known as "trend inflation" or "underlying inflation."

According to the Ministry of Statistics, consumer prices rose 2.8 percent in July from a year earlier, pulling back into the 2 percent range for the first time since May (3.1 percent). But the core inflation gauge — the index excluding food and energy — climbed 2.6 percent year-on-year, up 0.1 percentage point from June's 2.5 percent. That was the highest reading since December 2023 (2.8 percent), a gap of two years and seven months.

The Bank of Korea's current inflation target is pegged to the consumer price index. Since 2019, the central bank has aimed to keep year-on-year CPI growth at 2 percent. But the CPI was not always the benchmark of choice.

When the BOK first introduced inflation targeting in 1998, it used core inflation as its reference measure. The country was in the grip of the Asian financial crisis, and the central bank wanted to filter out temporary price distortions caused by external shocks and focus instead on the underlying inflationary pressures that monetary policy could actually address.

The shift to CPI as the target came in 2007. At the time, the BOK argued that core inflation excluded agricultural and petroleum prices — items that weigh heavily on household budgets — and therefore failed to reflect the inflation that ordinary people actually felt.

Both measures have clear strengths and weaknesses as policy targets. CPI offers stability, broad coverage, timeliness and wide public recognition; it also tracks consumer sentiment more closely because it includes oil and food prices. Core inflation, by contrast, is less susceptible to supply shocks, making it a more reliable guide for monetary policy decisions.

Former Federal Reserve Governor Frederic Mishkin argued that core inflation should serve as the yardstick for monetary policy, on the grounds that surges in oil or grain prices are not demand-driven and therefore respond poorly to interest rate increases. He also warned that reacting to every swing in headline CPI risks overreaction to temporary fluctuations, and noted that CPI tends to revert to core inflation over time — making core the more appropriate anchor for policy.

BOK Governor Shin Hyun-song's recent emphasis on core inflation fits the same logic. With consumer prices heavily distorted by supply shocks from the Iran war, the central bank is trying to cut through the noise of external variables and focus monetary policy on the underlying trend.

At a National Assembly briefing on July 29, Shin said maintaining a rate-hike stance to rein in core inflation "is the most rational course of action," adding that he views core inflation as the more important indicator.

A closer look at July's consumer price breakdown shows that second-round effects from higher oil prices are feeding through to other categories with a lag. Personal services inflation rose 3.5 percent, and personal services excluding dining out climbed 4.1 percent. Particularly notable were price increases in categories that tend to be sticky once they rise — insurance service fees (up 13.4 percent), apartment maintenance fees (3.5 percent), auto repair costs (6.1 percent), jeonse (1.1 percent) and monthly rent (1.2 percent). Oil prices spiked and then retreated, but the ripple effects are still pushing up prices across a range of other items.

Looking further ahead, the BOK believes that even if inflationary pressure from higher oil prices eases, demand-side factors — including strong economic growth and rising wages — will continue to push core inflation higher.

Shin's recent preference for gross domestic income over GDP reflects the same thinking. GDI measures the total income earned within a country and, unlike GDP, captures gains in income that stem from changes in export and import prices.

With export volumes surging — driven largely by a sharp rise in semiconductor prices — Shin believes GDI paints a more accurate picture of the economy than GDP. A rapid income surge led by semiconductors would boost private consumption and ultimately lift prices. Rising bonuses and wages in the IT sector are also adding to demand-side pressure.

Real GDI grew 3.6 percent in the second quarter, roughly six times the real GDP growth rate of 0.6 percent. On a year-on-year basis, real GDI rose 15.6 percent — the fastest pace since the first quarter of 1988 (16.4 percent), a gap of more than 38 years.

Shin's signal that he intends to sustain the rate-hike cycle after the Monetary Policy Board raised the benchmark interest rate by 25 basis points last month is widely seen as reflecting his view that demand-side pressures will persist for a considerable period.

Skepticism is growing both inside and outside the BOK. Some warn that aggressively raising rates while uncertainty over the Iran war remains high could backfire. A senior official in the financial sector said that while rate hikes are being discussed in the United States now, many expect the Fed to cut rates next year, and that "locking in a rate-hike stance while other central banks are treading carefully could be risky." There are also questions about how significantly semiconductor-driven demand factors will ultimately feed through to inflation, with many saying the impact needs to be monitored over time.

The BOK's Monetary Policy Board will set the benchmark interest rate at its policy direction meeting on Aug. 27. Attention is focused on whether the central bank will deliver a consecutive rate hike, buoyed by a surprise second-quarter growth figure and July's elevated core inflation reading.