Nov. 23 (Bloomberg) -- Hungarian central bank President Zsigmond Jarai said he may cut interest rates for a seventh time this year and predicted more reductions next year as the highest borrowing costs in the European Union slow inflation. Bond yields dropped close to one-year lows.

``Inflation is slowing in Hungary and this may create the opportunity for further rate reductions,'' said Jarai in an interview late yesterday in Budapest. ``I can imagine that we will have single-digit interest rates by the end of the year.''

Policy makers will next meet on Dec. 20, after reducing the benchmark rate by half a point to 10 percent yesterday. Jarai said a benchmark interest rate of about 8.5 percent at the end of 2005 is the ``most likely scenario.'' Consumer price inflation slowed to 6.3 percent in October, the lowest pace this year, and Jarai said inflation may fall to 5 percent in January.

Hungary needs lower interest rates to spur economic growth, which slowed to 4 percent in the second quarter from 4.2 percent in the first, and meet terms for adopting the common European currency. Lower borrowing costs depend on the government's willingness to trim the budget deficit, Jarai said.

``To keep real interest rates steady, beside slowing inflation, we need lower nominal interest rates,'' Jarai said. ``There may be some factors that cause a divergence: on the positive side, should the government speed up the consolidation of public finances, or on the negative side if the state of the budget deteriorated further and it turned out the euro cannot be introduced in 2010.''

Euro Terms

The forint rose to 244.91 against the euro as of 10:49 a.m. in Budapest from 245.28 late yesterday. The forint has gained 7.3 percent this year, making it the world's fifth-best performing currency against the euro.

The yield on the benchmark 2007 bond fell 14 basis points, to 8.80 percent, while the yield on the 2009 bond shed 5 basis points to 8.40 percent. A basis point is 0.01 percentage point Bonds have soared in the past two months on rate-cut expectations, with yields dropping to one-year lows.

Hungary, which joined the EU in May must trim its budget deficit to 3 percent of gross domestic product to meet euro- adoption requirements. It must also bring down inflation to within 1.5 percentage points of the average inflation rate of the three EU members with the lowest inflation rates. That would have been 2.4 percent in August, according to the European Commission.

Euro Timetable

Of the seven other eastern European nations that joined the EU this year, Lithuania, Estonia and Slovenia plan to adopt the common currency in 2007, Latvia in 2008 while Poland, the Czech Republic and Slovakia want to switch in 2009 or 2010.

``The market believes that rates can be cut along with the slowdown in inflation but this can't go on like that forever,'' said Laszlo Kishonti, who helps manage the equivalent of $600 million in mostly Hungarian stocks and bonds at KBC's Budapest- based fund management unit. ``Rate cuts are done along a very shaky path. Hungary is a very risky country. As soon as the currency comes under pressure, rate cuts may come to a halt.''

Declines in the currency may be triggered by Hungary's high current account deficit, which are mostly financed by inflows into bonds and stocks, which makes the forint vulnerable to fluctuations, Kishonti said. A weakening currency, in turn, will fuel inflation. The central bank forecasts the current account deficit at 9 percent of GDP this year.

The central bank yesterday cut its inflation forecast for December to 5.9 percent from 6.1 percent estimated in August. It reiterated its expectation for the December 2005 annual rate at 4.4 percent.

Slowing Inflation

``There will be a fast drop in the inflation rate at the beginning of the year, which may be followed by fast interest-rate cuts, and then the interest rate will stabilize at lower levels,'' Jarai said.

The bank forecast this year's budget deficit at 5.6 percent of gross domestic product. It expects the shortfall at 5.5 percent of GDP next year, and 4.9 percent in 2006, all higher than the government's targets. The government seeks to trim the deficit to 4.7 percent next year and 4.1 percent in 2006.

The discrepancy between the bank's and the government's estimates was because the government overestimated value-added tax revenue and underestimated spending, Jarai said.

``The government is planning a very slow consolidation of public finances and it doesn't even stick to it,'' Jarai said. ``The closer we get to 2010, the narrower the maneuvering room gets and the likelihood of meeting the target diminishes.''

To contact the reporter on this story: Agnes Lovasz in Budapest at alovasz@bloomberg.net.

Last Updated: November 23, 2004 06:04 EST