This is what's in store for Korea after hitting 12-year low inflation

Low inflation coupled with weak exports would justify a policy rate cut.

According to Morgan Stanley, Korea's CPI inflation declined to 1.2% YoY in August (vs. 1.5% YoY in July), the lowest level in 12 years, since May 2000. It was below consensus forecast of 1.4% and our forecast of 1.5%. The lower CPI inflation was partly due to the high base in August last year.

Here's more from Morgan Stanley:

On a sequential basis, CPI inflation increased 0.4% MoM in August, after the decline of 0.2% MoM in July. Core inflation (CPI excluding food and energy) was at 1.3% YoY in August (vs. 1.2% in July), much lower than the 2.1% in 1H12 and 3.2% in 2011, indicating that the overall inflationary pressure is coming down.

The breakdown showed that food inflation was only at 0.4% YoY in August (vs. 2.4% in July), due to the high base last year. On a sequential basis, food prices saw a 1.1% MoM rise in August (vs. -0.8% MoM in July), as typhoons and the hot weather pushed up vegetable and fruit prices in the month.

Prices in miscellaneous products continued to show a decline of 4.9% YoY in August (vs. the decline of 5.5% in July), due to the government's subsidies in services, such as free childcare and free school lunches. On the other hand, transport price inflation was at 1.8% YoY in August (vs. 1.2% in July), due to the higher fuel prices caused by the rise in international oil prices. Housing/utilities increased 4.7% YoY in August (vs. 4.8% in July), suggesting that housing rents stayed at a high level in Korea.

The weak exports and low inflation in August would justify an imminent policy rate cut, in our view. The Bank of Korea's inflation target was at 2-4%, and real interest rate would rise to the highest level since 4Q 2007. As GDP growth decelerated to 2.4% in 2Q12 (from 2.8% in 1Q and 3.6% in 2011), we believe the Bank of Korea has enough room to cut the policy rate to support the economy. We think a lower interest rate would: 1) ease the interest payment burdens of households, and 2) support business confidence in the weak economy. The Bank of Korea will hold the monetary policy meeting next Thursday (September 13), and we think a rate cut of 25 bps is possible.

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