Inflation is running well above the bank's 4 percent upper target, despite a slight fall in April, and consumers expect it to remain there, indicating that the central bank had failed to anchor expectations after it and the government both had said fighting inflation was their top goal.
"The board decided to take a cautious decision given external and internal risk factors such as domestic savings banks' problems," Bank of Korea Governor Kim Chong-soo told a news conference after the rate decision.
The bank left its 7-day repurchase agreement rate unchanged at 3 percent for the second month in a row, although last month's decision had been in line with market expectations. "I acknowledge that there must be a gap (between the bank and investors) in terms of the amount of information available," Kim said.
Seventeen of 19 economists polled by Reuters had expected a 25 basis point rate hike this month and had expected the Bank of Korea to raise rates to 3.75 percent by the end of this year.
KIM SIGNALS MORE CAUTION TO COME: As it is, real interest rates in Korea stand at a negative 1.2 percentage points, in sharp contrast to Malaysia's central bank which has moved pre-emptively to contain inflation and increased rates earlier this month.
"With inflation running uncontained for a time, there is a risk the Bank of Korea will have to implement a vicious tightening cycle later," said Young Sun Kwon,Nomura's Senior Korea Economist.
The dilemma faced by Kim and other policymakers in Asia's fourth-largest economy is that its turbocharged export sector contributed 90 percent of the 1.4 percent quarter-on-quarter economic growth in the first three months of 2011. Without exports, that figure would have been a sickly 0.2 percent.
While global players like Kia Motors are reporting record sales in key markets, South Korean consumers are weighed down by some of the highest levels of debts in the developed world, construction is contracting and small savings banks are threatened with collapse.
"I calculate the output gap at 5 percent. The output gap has failed to close despite one of the most vigorous export-led recoveries in Asia and it has not been transmitted to the services sector via higher employment," said Tim Condon, Chief Economist for Asia at ING Singapore.
Kim, who in April said that the central bank had raised rates four times in the past year and had acted "appropriately", projects annual average consumer inflation to be 3.9 percent this year, less than International Monetary Fund expectations for 4.5 percent.
"We are probably going to see the rate at 3.5 percent by the end of this year, with a single hike taking place each quarter. I do not expect a hike next month. The Bank of Korea will be cautious," said Lee Sung-kwon, chief economist at Shinhan Investment Corp who forecast that rates would be held today.
Bond futures prices jumped and the won fell after the decision. June-delivery futures on three-year treasury bonds rose 0.20 points to 103.58 by 0345 GMT while the won fell to 1,091 to the dollar from 1084.90 at Friday's open.