Magyar Nemzeti Bank said the bank base rate would be cut to 6.50 percent,while the rate on overnight deposits was cut by 100 basis points to 5.50 percent and the rate on overnight collateralised loans by 100 basis points to 7.50 percent.
"Overall, expected developments in inflation and financial markets as well as persistently weak demand warrant an easing of current monetary conditions," the bank said after a meeting of its Monetary Council.
"The Council will consider a further reduction in interest rates if the improvement in financial market sentiment persists and medium-term upside risk to inflation remain moderate," it added.
Hungary's central bank surprised markets last month by cutting its rate by 25 basis points and some economists had expected the central bank to follow-up with another rate cut this month.
Hungary has been struggling to contain inflation, which rose to an annual rate of 6.0 percent in August from 5.8 percent in July. In December 2011 the central bank had raised interest rates by 50 basis points to stem inflation.
Inflation is expected to remain "significantly above the 3 percent target for most of the forecast period, with the target only likely to be met in the second half of 2014," the bank said.
But the economy has weakened sharply this year and in the first quarter Gross Domestic Product shrank by 1.0 percent and then by another 0.20 percent in the second quarter for a 1.3 percent decline compared with the second quarter of 2011.
The central bank said it expects domestic demand to remain "persistently weak, reflecting falling real incomes, continued balance sheet adjustment and tight lending conditions."
An extremely poor harvest is likely to cause a further worsening in this year's outlook for growth and the economy is expected to grow slowly next year, supported by an expected recovery in Europe.
Meanwhile, there has been an improvement in financial markets and in the perceived risk of investing in Hungary. The central bank expects a further fall in risk premia as long as Europe is successful in tackling its debt issues and the Hungarian government reaches agreements with the European Union and the International Monetary Fund.
"Financial market sentiment has improved and the outlook for economic activity deteriorated around the world over the past quarter," the central bank said, adding:
"The contrast between improved perceptions of risk and very subdued economic activity has been reflected in domestic economic developments recently," the central bank said.
A weak economy and spare capacity is expected to dampen the inflationary impacts of costs shocks, according to most members of the monetary council.
However, the bank's statement also reveals a discussion in the council about the crises and its damage to the economy's productive capacity and potential growth rate. This may affect how much spare capacity the economy really has and how cost shocks affect inflation expectations.