Bank of Korea lifts rates; more hikes expected

Stacks of Korean won are put together before being delivered to commercial banks during a photo opportunity at the Bank of Korea in Seoul January 21, 2009.

SEOUL (Reuters) - The Bank of Korea raised interest rates on Friday for the first time since the outbreak of the financial crisis and cemented market expectations of more tightening by predicting solid growth and higher inflation ahead.

The central bank lifted its base rate by 25 basis points from a record low of 2.0 percent, joining regional peers from Australia, to India, Taiwan and Malaysia in the campaign to return policy to pre-crisis mode.

Investors have been pricing in a rate rise for several weeks given signs of authorities' growing confidence that Asia's fourth-largest economy can sustain its recovery, despite lingering doubts about the outlook for U.S. and European economies.

However, most analysts polled by Reuters had expected a move either in August or September and bond futures fell sharply right after the decision, though later recovered much of the losses.

The won extended gains to more than 1 percent on the day against the dollar. Stock prices were little changed.

"It appears that policymakers across Asia are reasonably confident about the economic outlook despite concerns about the potential impact of euro area weakness and a near-term dip in growth from the fast pace set earlier this year," said Brian Jackson, senior emerging markets strategist at Royal Bank of Canada in Hong Kong.

"We forecast the Bank of Korea to hike rates another 50 basis points by the end of the year, with risks increasingly skewed to the upside."

Graphic on interest rate and inflation trends, click here

Bank of Korea Governor Kim Choong-soo told reporters the economy probably expanded by more than 7 percent from a year earlier in the second quarter and the whole of the first half, another sign of solid recovery from the global slump.

He also said annual inflation was set to exceed the 3 percent mid-point of the central bank's 2-4 percent target range next year, which markets took as a hint the central bank would bring rates closer to 3 percent by the end of the year.

He also noted a sharp rise in mortgage lending in June after a period of subdued growth.

"There's no doubt that the base rate of 2 percent was very low when taking into account various factors such

as economic growth and inflation prospects." Kim said.

Kim voiced optimism that the global economy would continue to grow, but singled out Europe's fiscal problems as the main risk and said more financial market turbulence was possible.

This, combined with assurances that even after this week's rate rise monetary policy would remain accommodative, suggested that any further tightening would be cautious.

"As the base rate is still very low and the pace of tightening is very gradual, it is supportive for the economy and the impact on the market won't be negative," said Lee Sung-kwon, economist at Shinhan Investment Corporation.

Since mid-April, world financial markets have been dogged by concerns about the impact of Europe's austerity drive on global growth and fears that recovery from the worst economic downturn in decades may stall and lead to a double-dip recession.

This week's move was the first rate rise since August 2008 and the first rate change since early last year when the central bank finished its easing campaign that shaved off a total of 325 basis points of its benchmark rate.

(Editing by Jonathan Hopfner and Tomasz Janowski)

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