Bank of Mexico hikes rates amid fears of rising inflation risks

The governing board of the Bank of Mexico increased interest rates by 25 basis points to 7.75% on June 21, to tackle heightened inflationary pressures.

The board voted unanimously to hike rates to counter increased inflationary risks. It said these were caused especially by higher energy prices and a continued fall in the peso.

Annual headline inflation continued to decrease, from 4.55% in April to 4.51% in May, the central bank said.

Over the past two months, the peso has depreciated by 12.7% to 20.3 against the dollar today (June 22), from 18 to the dollar on April 17. The Mexican currency has shared a similar evolution with other emerging currencies, such as the Argentinian peso and the Brazilian real. Higher interest rates in the US are contributing to capital outflows from these countries and the depreciation of their currencies.

Carlos de Sousa, Latin America senior economist at Oxford Economics, tells Central Banking the Bank of Mexico “is a particularly hawkish central bank that takes exchange rate fluctuations very much into account for the setting of its monetary policy”. This is true, says de Sousa, especially if the central bank “expects depreciation pressures to be long-lasting and affect the trajectory of inflation going forward”.

In contrast to other emerging markets, de Sousa considers the peso’s weakness is not primarily linked to the Fed’s rate hikes. Instead, he thinks the main cause of the depreciation is the prolonged negotiations to modify the North Atlantic Free Trade Agreement between the US, Canada and Mexico. 

“The renegotiation of the trade deal is no longer expected to be completed in a matter of weeks but most likely in 2019,” says de Sousa. “I don’t think Banxico would have followed the Fed if it wasn’t for the expected delay in the Nafta negotiation process, as Mexico’s monetary policy stance is contractionary enough.”

The Bank of Mexico initiated the current tightening cycle in early 2016 to tackle the higher inflation derived from the depreciation of the peso against the US dollar. The overnight interbank rate has been raised to the current 7.75% from 3.25% in February 2016.

The election of Donald Trump as US president in November 2016 may have helped reinforce this development, as one of his stated priorities is to reduce the US trade deficit with Mexico. According to the US government, the trade deficit with Mexico amounted to $64.1 billion in 2017.

Possible future hikes

In the statement, the central bank says “monetary policy will be adjusted timely and opportunely to bring inflation to the target”. In the previous decision in May, the central bank said this adjustment would take place “if necessary”.

The removal of this expression leaves the door open for another hike, say João Pedro Bumachar Resende and Alexander Müller, economists at bank Itaú BBA. “We now expect Mexico’s central bank to increase the policy rate once more (to 8%) in its next meeting, to be held in August,” they say.

“In our view, the communication of the central bank indicates that – unless risks related to Nafta, domestic policies after elections and monetary policy in the US moderate – more tightening is likely.”

In contrast, Fernando Murillo, senior Mexico analyst at Oxford Economics, thinks the Bank of Mexico will remain on hold in the second half of 2018. “We see pessimism as overblown on key topics such as the dollar rally, Mexico’s presidential election and Nafta negotiations,” he says. “Nafta talks paralysis will break after Mexico’s 1 July elections and metal tariffs will be removed for Canada and Mexico once a ‘revitalised Nafta’ is in place.”