The Bank of Korea surprised markets on Thursday with a controversial decision to raise interest rates to a seven-and-a-half year high as it was squeezed unhappily between surging inflation and a weakening economy.

Some analysts fear that the rise could provoke severe instability in Korean households where finances are vulnerable.

Families have taken on high levels of debt over the past few years, and in more recent months have further cranked up their exposure to regional and domestic markets by plunging nearly a quarter of their assets into equities.

“It is fair to say Korean household balance sheets have never been more leveraged to interest rates,” said Shaun Cochran, chief Korea economist at CLSA, the securities firm.

The increase - the central bank’s benchmark interest rate rose 25 basis points to 5.25 per cent - was South Korea’s eighth increase since autumn 2005 and came amid deepening criticism of the authorities for allowing inflation to spiral out of control.

With few natural resources and a manufacturing economy that depends heavily on imported metal and energy commodities whose prices have far outstripped predictions, South Korean inflation is running at a decade-high of 5.9 per cent.

Even if softening oil prices take some of the edge off the rate in coming months, Lee Seong-tae, the Bank of Korea’s Governor, today admitted that his target inflation range of between 2.5 and 3.5 per cent will remain out of reach for a considerable period.

The interest rate rises come after a tumultuous few months for South Korea’s new administration, which has had to cope with a nosedive in public approval ratings, mass demonstrations calling for the new President to resign and transport strikes that briefly crippled the nation’s export-driven economy. Koreans are more pessimistic about things than they have been for many years, according to the polls.

The South Korean economy has not yet been too badly savaged by the early stages of a global downturn, thanks to the strong performance of its industrial groups such as Samsung and LG. But most analysts believe that such immunity will be short-lived, and expect the central bank to target the prospect of stumbling growth.

However, Mr Lee said that Thursday’s rise was justified because it remained too early for the central bank to drop its focus on rising prices. “It is not yet time for monetary policy to focus only on slowing economic growth because the inflation risk remains in place,” he said.

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