BUDAPEST ECB President Mario Draghi said on Friday that Hungary's central bank must retain its independence to be credible - a rare public warning about undue political influence ahead of a change in the bank's leadership.
Draghi's remarks coincided with the latest in a string of calls by ministers for closer co-ordination between Prime Minister Viktor Orban's government and the National Bank of Hungary to shore up central Europe's most indebted economy.
The central bank has been at loggerheads with Orban's government for over two years and perceived threats to its independence have also brought clashes between Hungary, the European Commission and the European Central Bank itself.
Orban, who has appointed people close to his Fidesz party to key public posts since taking power in 2010, will pick a new governor in February to replace Andras Simor, whose six-year mandate expires in March.
Some analysts are concerned Orban will choose a loyalist, which could make the bank more politicised and usher in unconventional steps to boost growth ahead of 2014 elections.
Rate-setters already appointed by the ruling Fidesz party's parliament majority have outvoted Simor and his deputies in the past four months, cutting rates to aid the sickly economy.
"A key prerequisite for a credible monetary policy is the independence of the central bank," Draghi told a conference in Budapest organised by the National Bank of Hungary.
"The ultimate success of a central bank in maintaining price stability depends on its credibility."
Independence means the central bank must have the means and instruments needed to achieve its price stability objective without being influenced by outside forces, Draghi added.
He also said lowering interest rates in an indebted economy may risk weakening its currency, which might in turn lead to higher inflation and offset the impact of economic stimulus.
"Credible inflation-targeting in small open economies also depends on central banks' recognition of the impact of their monetary policy decisions on the exchange rate," Draghi said.
"For example, in the presence of heavily indebted private and public sectors with large open foreign exchange positions, central banks have little space for manoeuvre when faced with a flagging economy."
Hungary's central bank has cut interest rates by a total 100 basis points in the past four months to 6 percent, and more easing is expected, with a clear majority of Monetary Council members now prioritising economic growth over inflation risks.
Two of the four dovish rate-setters said in a newspaper interview earlier on Friday that the bank could cut rates further, and that the base rate could realistically be lowered to around 5 percent by the end of 2013.
One of them, Ferenc Gerhardt, said further rate cuts depended on the forint's exchange rate, the cost of insuring Hungary's debt against default, and bond yields. He did not mention inflation risks, but the four doves have said depressed demand will keep a lid on inflation.
Simor and his two deputies, who were appointed under a previous government, have opposed the bank's recent rate cuts, warning about the risks of inflation sticking at higher levels and a potential market backlash later.
He told the same conference on Friday that monetary policy can stimulate economic growth only as long as it does not jeopardise price stability.
He said letting inflation loose was not the way to produce lasting additional growth in the economy. Hungary's annual inflation was running at 6.0 percent in October, double the bank's 3 percent medium-term target, which it has said could be achieved in 2014.
"In my opinion, when inflation expectations, i.e. the longer-term inflation outlook, become uncertain, the central bank should act much more firmly to keep price and wage-setting behaviour disciplined," Simor said in a speech.
He said fiscal consolidation in Hungary must be made credible and debt must be put on a sustainable declining path. The government has kept the budget deficit below the EU's 3 percent ceiling this year, mostly by taxing banks and foreign energy and telecoms firms, avoiding austerity measures.
While Orban has refrained from criticising the central bank in the past few months, he has suggested in the past that it could do more to help the economy.
His economy minister has proposed monetary stimulus measures, but it is unclear at this stage what exact steps the bank might take after the new leadership takes control.
Minister Mihaly Varga, who is in charge of Hungary's stalled loan talks with the International Monetary Fund, told a newspaper on Friday that changes at the bank next year will enable a "harmonisation of fiscal and monetary policy".
Varga, seen by some as a potential candidate to replace Simor, and who was present to hear Draghi's speech in Budapest, ruled himself out of the running for the post of governor.
"An opportunity will arise for the harmonisation of monetary and fiscal policy," Varga was quoted by business daily Napi Gazdasag as saying in an interview.
"Naturally, there will not be full harmony, as the two actors, government economic policy and the central bank have partly opposing roles," the minister added.
(Additional reporting by Sakari Suoninen; Editing by Jeremy Gaunt and Catherine Evans)