UPDATE 1-Hungary central bank outlines risks to its policy outlook

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BUDAPEST, March 26 (Reuters) - Hungary’s central bank said on Thursday that persistently low domestic inflation or prolonged deflation in the euro zone could force it to loosen policy more than currently flagged.

The bank, in its inflation report, also addressed the risk of a Greek exit from the euro zone, saying an orderly exit should not have a direct effect on Hungary’s monetary policy. However, a disorderly exit that caused mayhem in financial markets could force Hungary to tighten monetary policy to prop up the forint, it said.

On Tuesday the bank cut interest rates for the first time in eight months, resuming a rate cut cycle it halted in July with a 15 basis point first reduction to 1.95 percent. It also flagged further cuts to ensure meeting its 3 percent inflation target, although it did not say how low rates could go.

“The consumer price index is only expected to approach the medium-term target (3 percent) at the end of the forecast horizon (6-8 quarters), after the first-round effects of cost shocks wear off,” the bank said in the inflation report.

Inflation has disappeared as consumer prices have been falling for months due to cuts in household energy bills and the slide in oil prices. The inflation report forecast that the oil price would average $61.3 per barrel this year and $68.8 in 2016, both sharply below previous estimates.

The euro zone buys most of Hungary’s exports and prolonged deflation in the currency bloc would pose downside risks to Hungarian inflation and growth, requiring looser monetary conditions than in the baseline view, the bank said.

If persistently low domestic price growth pushes inflation expectations away from the bank’s 3 percent target, that would also prompt a sharper loosening of policy, it said.

In contrast, a steep rise in Hungary’s risk premium and falls in the exchange rate, possibly driven by any escalation of the conflict between Russia and Ukraine or risks stemming from debt-ridden Greece exiting the euro zone, a so-called Grexit, could trigger policy tightening.

“The CEE region’s real economic relations with Greece are not significant, and thus as long as it takes place in an orderly form, a potential Grexit would have no major direct impact,” the central bank said.

“However, if the unified nature of EMU breaks down, Greece’s exit from the euro area could have considerable negative impacts on the financial and capital market,” it said. (Reporting by Gergely Szakacs; Editing by Susan Fenton)