March 28, 2017 / 12:07 PM / 5 months ago

UPDATE 2-Hungary central bank dovish despite higher inflation, caps deposits

(Adds central bank comments, market impact, analyst comment)

* Base rate unchanged at 0.9 pct, as expected

* Bank reduces cap on 3-month deposits further

* Raises 2017 avg inflation forecast to 2.6 pct

* Says current inflation rise temporary

By Krisztina Than and Gergely Szakacs

BUDAPEST, March 28 (Reuters) - Hungary's central bank kept its base rate on hold on Tuesday and opted for further unconventional monetary easing, squeezing more funds than expected from its main three-month deposit tool into the economy to help drive down borrowing costs.

With the bank ruling out further cuts in its main policy rate, reducing the stock of its three-month deposits has emerged as its key tool to curb market interest rates and so make bank loans cheaper for businesses and households.

Despite a jump in inflation in past months, the central bank kept its dovish bias and squeezed out more funds from its deposit tool than analysts in a Reuters poll had predicted.

The Monetary Council said it was "ready to ease monetary conditions further using unconventional, targeted instruments" if inflation remained persistently below its target.

"The Bank continues to aim to maintain loose monetary conditions and provide a corresponding degree of support to the economy through money market rates," the Council said in its statement.

The bank reduced the cap on the amount of funds in its main three-month deposit tool to 500 billion forints ($1.75 billion) by the end of June, less than the poll's median projection of 600 billion forints.

It had previously capped deposits at 750 billion forints by end-March.

"The central bank's comments had a market impact, as FRAs (forward rate agreements) moved downwards ... and we expect that three-month interbank rates will decline in coming months and continue to converge to zero, while the base rate stays unchanged," Erste Bank analyst Gergely Urmossy said in a note.

The central bank said that banking sector liquidity could decline in the second quarter, partly due to maturing swap contracts, and that with the new cap it wanted to "maintain the loose monetary conditions achieved".

The bank also decided to introduce new six- and 12-month swap instruments providing forint liquidity.

Inflation picked up to 2.9 percent in February, but the bank said the rise would be temporary.

By 1344 GMT, the forint weakened to 309.70 versus the euro from 309.22 before the announcement.

The three-month Budapest Interbank Offered Rate has sunk to 0.21 percent on Tuesday, well below the base rate.

According to the median forecasts in the Reuters poll, the base rate will not change this year but could rise to 1.2 percent by end-2018.

$1 = 284.68 forints Reporting by Krisztina Than; Editing by Catherine Evans

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