Bank of Mexico hints at tougher measures as it raises rates

The Bank of Mexico continued its policy tightening, but it said it is willing to deploy tougher measures to bring inflation back to target.

The governing board voted to increase the key policy rate by 50 basis points to 7% on May 12. This is the fourth consecutive 50bp rate hike, and the eight consecutive rate increase overall since June 2021, when interest rates stood at 4%.

Irene Espinosa was the five-member body’s only dissenter, voting instead for a 75bp rate increase. Espinosa is the only board member not appointed by Mexican president Andrés Manuel López Obrador.

The rate rise came eight days after López Obrador’s government unveiled a programme aiming to reduce inflation. The government says it will subsidise energy prices and seek to boost food production.

“The balance of risks for the trajectory of inflation within the forecast horizon remains biased to the upside and continues deteriorating,” says the board’s policy statement. “Given the growing complexity in the environment for inflation and its expectations, taking more forceful measures to attain the inflation target may be considered.”

In April headline inflation increased year on year by almost 7.7%, and core inflation by over 7.2%, according to official data. These are the highest readings since January 2001.

Banxico revised up its March inflation expectations. Now it forecasts headline inflation for the third quarter of 2022 to average 6.4%, up from 5.5%. The projections for the first quarter of 2023 were increased from 4.5% to 5.3%.

The central bank now forecast core inflation will average 5.9% in the fourth quarter of 2022, up from 5.2% in its March projections. In the first quarter of 2023, Banxico estimates core inflation will increase by 4.8%, up from 4.1% in its March projections.

Nonetheless, the central bank maintains its expectation that inflation will converge to the 3% target in the first quarter of 2024.

The central bank pointed to three main inflation risks: the Covid-19 pandemic’s effects, pressure on agricultural and energy prices due to the Russian invasion of Ukraine, and exchange rate depreciation.

Higher interest rates in the US tend to put downward pressure on the Mexican peso, as investors seek higher returns and safety in US Treasuries. Although the Federal Reserve started increasing rates in March and delivered a 50bp rate increase this month, the peso has so far remained stable.

Inflation plan

Food and fuel prices are two of the main factors boosting inflation in the Mexican economy. In April, food inflation increased by close to 11%, and energy products by almost 6%.

Mexico’s government unveiled a plan on May 4 to contain fuel prices and boost the production of staple products.

The government will subsidise fuel prices, and says it has agreed with business leaders to increase production of corn, rice and beans. The programme will not involve price controls, López Obrador said. These measures will remain in place for six months and could be renewed if deemed necessary.

The plan is “not as interventionist as might have been feared”, says William Jackson, chief emerging markets economist with Capital Economics.

Nonetheless, it remains unclear whether these measures will be effective and to what extent they will contribute to reduce headline inflation.

“While some prominent retailers have signed up, it’s not clear whether they will freeze prices of all the goods in the plan,” says Jackson. Additionally, energy subsidies entail an estimated fiscal cost of 1.4% of GDP. “This won’t make a major dent in the public finances. Mexico’s public debt ratio is one of the few in the region that’s on a broadly stable path. But it’s an inefficient use of public funds,” he adds.

All in all, Jackson thinks the plan should help to reduce inflation. According to his calculations, if it succeeds in stabilising the prices of goods included in the programme, inflation will be around 0.5 percentage points lower by the end of the year than it would have been otherwise.

However, this will not be enough to reverse a challenging inflation outlook. The inflationary cycle the Mexican economy is going through “has a bit further to run in the near term”, says Nikhil Sanghani, emerging markets economist with Capital Economics.

The consultancy forecasts headline inflation is likely to increase slightly more and then stay close to 8% until the end of the second quarter. Afterwards, it will start gradually falling.

The government’s intervention “will help to keep a lid on food and energy prices, and inflation in these categories will soon fall due to base effects”, says Sanghani. “That said, ongoing goods supply shortages and the impact of the re-opening of Mexico’s economy will keep upward pressure on prices more broadly in the coming months.”