Hungary's central bank, which earlier today cut its base rate by 15 basis points to 2.85 percent, said it may continue to cut rates in light of the outlook for inflation, but a reduction in the size of the rate cuts had become warranted in light of the risks and the improving economy.
The National Bank of Hungary, which cut its rate for the 18th time in a row, said investors' sentiment toward Hungarian assets remained supportive despite the U.S. Federal Reserve's decision to reduce the size of its asset purchases, as shown by lower bond yields and spreads on credit default swaps (CDS).
However, the central bank also acknowledged that a "cautious approach to policy is warranted due to uncertainty related to the global financial environment."
"Considering the outlook for inflation and taking into account perceptions of the risks associated with the economy as well as the improvement in the pace of economic growth, further cautious easing of monetary policy may follow, but a reduction in the increment has become warranted," the bank said.
The central bank has now cut rates by 415 basis points since embarking on its easing cycle in August 2012 but reduced the pace of its rate cuts to 20 basis points from 25 basis points in August 2013 following massive capital outflows from many emerging markets as global investors started to reassess the prospects for growth and the Fed signaled it was considering its exit from quantitative easing.
Although Hungary's forint has held up much better than many other emerging market currencies, such as the currencies of Indonesia, Turkey and India, the central bank is very aware that investors' sentiment that quickly change.
"A sustained and marked shift in perceptions of the risks associated with the Hungarian economy may influence the room for manoeuvre in monetary policy," the bank said.
But Hungary's inflation rate is low and the economy is improving, helping attract global investors.
Hungary's inflation rate fell to a 43-year low of 0.4 percent in December, continuing the steady decline since September 2012 when inflation hit 6.6 percent, and the central bank said "there remains a significant degree of unused capacity in the economy and inflationary pressures are likely to remain moderate over a sustained period."
The drop in December inflation was mainly due to lower regulated energy prices, the bank said, adding that its own measures of underlying inflation also indicated moderate inflation pressures due to weak domestic demand and low inflation abroad.
"The persistently low inflation environment may facilitate the adjustment of inflation expectations," said the central bank, which has said it expects inflation to slowly move back toward its 3.0 percent target by the second quarter of 2015.
Hungary's economy is expected to continue to improve this year and next year, but the central bank said the level of output remains below the economy's potential and while unemployment is starting to fall, it still exceeds its long-term level so "inflationary pressures in the economy are likely to remain subdued over the medium term."
Hungary's economy expanded by 0.9 percent in the third quarter of 2013 from the second quarter for annual growth of 1.8 percent, up from 0.5 percent in the second quarter.
The latest economic data show that growth has continued in the fourth quarter, with domestic demand expected to continue to strengthen and exports to rise, the bank said.