South Korea's central bank is expected to slash its key interest rate in October in the wake of its August rate cut due to a slow recovery in the country's economy and volatile foreign exchange rates, market watchers said Sunday.

In August, the Bank of Korea cut the base rate to 2.25 percent from 2.5 percent, the first rate reduction in 15 months, in an effort to lend support to the government's efforts to boost the economy. Last month, the central bank froze the rate as widely expected.

The BOK is scheduled to hold its October rate-setting meeting on Oct. 15.

"On the local bond market, investors are widely forecasting an additional interest rate cut, amid the steady weakening of the Japanese yen versus the Korean won," said Lee Jung-joon, an analyst at HMC Investment Securities Co.

The forecast of another rate cut comes amid growing concerns that negative factors at home and abroad are hurting the recovery of Asia's fourth-largest economy.

According to a report by Statistics Korea, the country's industrial output shrank at the sharpest pace in nearly six years in August, raising jitters that the economic recovery might be losing steam.

Production in the mining, manufacturing, gas and electricity industries fell 3.8 percent in August compared with July. This marked the largest on-month drop since December 2008, when it contracted 10.5 percent.

However, sales at South Korea's three major discount outlet chains and department stores grew from a year earlier in August, fending off worries over faltering domestic demand and putting the BOK in a dilemma.

The combined sales of the country's three major discount outlet chains increased 3.2 percent on-year last month, marking a sharp turnaround from an on-year drop of 4.6 percent in the previous month, according to the Ministry of Trade, Industry and Energy.

"We may have to decide (whether it is needed to raise the key interest rate) after reviewing indicators and data favorable for assessing economic conditions until the opening of the rate-setting meeting slated for Oct. 15," said a member of BOK's monetary policy committee, on condition of anonymity.

In addition to the weak economic recovery, the volatility of foreign exchange rates is lending weight to predictions of an interest rate cut in October.

The South Korean won has been losing against the U.S. dollar since June, when the local currency finished at an average 1,018.70 won per the dollar. Last week, the won sharply fell to the 1,060 won mark.

In contrast, the won has been gaining versus the Japanese yen, hurting South Korean exporters' earnings. The won traded at an average 1,003.66 won per 100 yen in July. The local currency rose to an average 963.16 won per 100 yen in September.

Hit by the currency volatility, the benchmark Korea Composite Stock Price (KOSPI) failed to break the 2,100-point level in late July and fell to the 1,970-point level.

The steady weakening of the yen against the won is weighing on large-cap exporters, leading to foreign investors' selling of local shares, market watchers said. (Yonhap)