* Central bank needs evidence market improvement lasting
* sees growth bottoming out in Q3
* expects inflation to fall to around 2 percent by H2 2009
(Updates with detail, debt agency comment)
By Krisztina Than and Balazs Koranyi
BUDAPEST, June 9 (Reuters) - Hungary's central bank needs clear evidence that the recent improvement in market sentiment is lasting before it can start cutting interest rates, bank Deputy Governor Ferenc Karvalits told Reuters on Tuesday.
He added that while this is being ascertained, the bank must exercise caution with policy moves as an ill-timed rate cut could endanger financial stability.
"Under the current conditions when exchange rates are so volatile, any kind of movement in the interest rate has (a) very limited effect on the short run and also involves high stability risk as well, so we have to be quite cautious concerning interest rate policy," Karvalits told Reuters in an interview.
"I believe we need robust evidence that these changes (in investor sentiment) became permanent before we can change the track of monetary policy," Karvalits added.
Karvalits' caution mirrors the bank's reserved tone since its last rate cut in January and highlights policymakers concern over the forint, which has firmed over 10 percent since early March but remains volatile.
He added that further global market volatility cannot be excluded, which also warranted some caution.
"Under these global risk appetite conditions, one can't exclude extreme (currency) movements but our monetary policy aim is to stabilise and smooth out these very volatile external conditions and we do our best to keep financial stability," Karvalits said.
Hungary averted financial meltdown late last year with the help of a $25.1 billion International Monetary Fund-led rescue package and has since relied almost entirely on international loans to refinance expiring debt.
BOTTOMING OUT
Karvalits added that he expected Hungary's economy to continue shrinking this year and growth would bottom out in the third quarter, when it could be around a negative 7 percent.
Hungary's economy contracted by an annual 6.7 percent in the first quarter and the government expects the economy to shrink by 6.7 percent in all of 2009.
Karvalits added that inflation could spike to 6.5 percent by the end of this year on the one-off impact of tax hikes but that the bank expected the impact of these tax hikes to quickly pass through inflation figures.
"I strongly believe that the effects of these changes in taxation will die out quickly and because of the very limited domestic demand, inflation will sink back down to around 2 percent by the second half of next year," Karvalits added.
Karvalits said Hungary was under no pressure to return to international markets to finance its expiring debt as it had the IMF facility at its disposal but the bank, along with debt agency AKK, was working on returning the country to market financing.
AKK Chief Executive Ferenc Szarvas, speaking at a business conference on Tuesday, also said the country's goal was to wean the budget off IMF aid quickly.
"The debt management agency's goal is to get Hungary off international aid as soon as possible and switch to full market financing," Szarvas said.
"The only way to do this is to react flexibly and use methods previously not used," Szarvas said. "We have to be opportunistic, use every possible solution that could work and we can't insist on tools that may have worked in the past," Szarvas said.
Szarvas added that it is possible Hungary would return to international markets soon with a eurobond offer but the debt agency would be flexible about such a sale as it take just a few days to launch a bond offer.
The first-quarter output drop reflected sharp decreases in spending on clothing, footwear, recreation, culture and also food, according to the statement.
(Reporting by Balazs Koranyi and Krisztina Than; editing by Patrick Graham)