Low Inflation in Korea During the Accommodation Policy Period 2012–2017: Unravelling the Mystery

During the period 2012–2017, Korea’s inflation slipped to a very low level, notwithstanding the accommodative monetary policy. Focusing on the transmission channel of lower interest rates on house rents, this study argues that the official consumer price index (CPI) in Korea understated the true inflation rate because Korea has a unique rental system, known as the chonsei contract. Under this contract, the tenant pays the landlord a large, lump-sum, upfront deposit without a periodic rent payment, and the landlord derives his returns from the interest accrued on the deposit. Thus, a cut in interest rates induces the landlord to offset the loss on his returns by charging the tenant a larger upfront deposit, which should have raised the CPI inflation. However, this effect was not properly captured owing to the growing prevalence of a hybrid chonsei contract, under which the tenant makes a periodic monthly payment as well as the upfront deposit. Thus, a low interest rate converts the upfront deposit paid under the hybrid chonsei into lower interest flows, significantly under-estimating the rent and CPI. An examination of the official CPI figures alone will in all likelihood misguide monetary policy.