The National Bank of Hungary's Monetary Council decided to cut the central bank's key rate by 25bp to 6.75% at a rate-setting meeting on Tuesday.
The rate change was the first since December 2011 and surprised analysts who had expected the rate to stay on hold till Hungary reaches an agreement on precautionary financing from the International Monetary Fund and the European Union. Other market players saw the chance for a rate cut as Hungary entered a recession in the second quarter and the country's risk premium fell.
The forint weakened against the euro from 278.7 to 280.3 immediately after the decision was announced.
Speaking at a press conference after the meeting, MNB governor András Simor said a proposal to keep the base rate on hold was made in addition to the one to cut the rate by 25bp. The latter proposal was supported by a "narrow majority", he added.
Asked why the decision to cut rates was taken when the effect on commercial banks -- who have raised rates even as the central bank base rate remained unchanged -- appears to be muted, Simor said the majority of Council members considered the cut justified because of the outlook for and trends in the real economy.
The effect of the rate cut on Hungarian government securities yields was not brought up at the meeting, he said, responding to another question.
In a statement published after the meeting, the Council said it took into account higher than expected inflation, a weakening in economic activity and improved risk perceptions associated with the Hungarian economy when taking the decision to reduce the base rate.
The Council said it would continue to "closely monitor" underlying inflation developments.
"Monetary policy can only be eased to the extent that supply shocks to the economy and the upward impact on prices of the government's measures do not lead to the build-up of second-round inflationary effects and perceptions about the Hungarian economy continue to improve," it said.
The Council said inflation was higher than expected inflation in June and July because of higher unprocessed food prices and a rise in excise duties, but inflationary pressure from the real economy "continue to be subdued" because of weakening domestic demand. Increases in indirect taxes affecting consumer prices are expected to keep CPI "significantly above" the central bank's medium-term target into 2013, although the risk of second-round effects is low due to persistently weak demand and slack in the labor market, it added.
The Council acknowledged second-quarter GDP data show Hungary is in a technical recession. Domestic demand likely to fall further in the coming quarters, while investments remain subdued because of the weak outlook for economic activity, the unpredictable business environment and tight credit conditions, it said.
The Council said the Hungarian economy's risk perceptions had fallen further, but driven "mostly by external factors".
"The government's commitment to maintaining a sound fiscal policy and to reaching an agreement with the European Union and the International Monetary Fund is crucial in terms of the future evolution of the risk premium," it added.
Asked whether the prospect of a quick decision on precautionary financial assistance Hungary is seeking from the IMF/EU was considered when taking the decision, Simor said he knew nothing about the continuation of talks on the matter.
The condensed minutes of the meeting will be published at 2pm on September 12.