Mexico: No Hurry to Ease

Mexico’s central bank is back in the spotlight following the Fed’s move to accelerate its rate-cutting cycle in January. The Fed’s moves (which in January alone totaled 125bp) − combined with a string of reports showing a slumping US economy – have raised expectations that Mexico’s central bank might not be far behind. Indeed, Mexico’s yield curve, which at the beginning of the year was still pricing in a hike by Banco de Mexico in 2008, is now pricing in at least one cut around mid-year.

While we agree that the next move by Banco de Mexico is likely to be a cut, we are much less optimistic that such a move is coming soon. Depending on the pace of the slowdown in the US and the strength of the link with Mexican economic activity, a rate cut in 2008 is certainly possible. But we doubt that a reduction in rates is coming any time soon. Indeed, we continue to believe that the most likely scenario is that Banco de Mexico keeps rates on hold during the year. Further, while the central bank’s talk has taken on a slightly more dovish tone − especially in its quarterly Inflation Report released on January 30 – we expect to see plenty of hawkish talk in the coming months. This could pose a risk to the developing view that a rate cut is nearby.

No hurry…

With the US economy slowing and the first signs that the spillover is also being felt in Mexico, why do we believe that Banco de Mexico is in no hurry to ease? We highlight three reasons to argue that a rate cut by Mexico’s central bank is unlikely in the near term:

First, demand pressures were never the problem driving Mexico’s inflation in the first place. Some softening in demand in Mexico is coming − indeed, it is already being seen in private consumption − but that provides Banco de Mexico with limited relief. Why? Because what has been driving Mexican headline and core inflation higher has largely been a series of external, supply-driven shocks, particularly among soft commodities, which have fed through to processed food. Banco de Mexico has argued that it has seen no meaningful demand pressure on inflation in 2007, even before the first signs of slowing consumption and external demand began to emerge in 4Q.

Unless domestic demand plummets in 2008 − which is not embedded in our forecast of 2.6% GDP growth for the year, nor embedded in the central bank’s forecast of 2.75-3% − Mexico’s inflation dynamic is likely to face more of the same: pressure from grains feeding through to processed foods. And with headline expected to bump back over 4% in the coming months, Banco de Mexico is likely to remain watching for any signs that the uptick in a broad range of food items is putting pressure on wages or on pricing decisions elsewhere in the economy.

Second, we fear that the inflation problem in Mexico will likely appear worse in the coming months before it looks better. Despite the run-up in processed food prices, there appears to be more pressure in the pipeline. In the three months ending in January, international corn prices have jumped 33%, while wheat is up 15%. Unless there is a rapid reversion, those increases are likely to work through from higher input prices into consumer products in the coming months. Whatever your view of where commodity prices are likely to end the year − we are biased towards lower prices later in the year, reflecting weakness in global demand − there are few signs of an immediate reversal in soft commodity prices.

Further, Mexico’s consumer basket could get hit in April once the voluntary discount campaign launched by Mexico’s principal supermarkets ends in March. And given very favorable produce price behavior in 2Q07, Banco de Mexico has warned that year-on-year comparisons are likely to be skewed to the upside in 2Q08. It is difficult to imagine that Banco de Mexico will ease its tone, much less interest rates, ahead of the May-June period when inflation appears to be on the rise.

Third and finally, Mexico’s central bank finds itself facing much less pressure to ease than the Fed. While the Fed is battling a downturn in the US, it is also facing the specter of a much more challenging environment for the financial system. In contrast, Mexico’s banking system is well capitalized and facing no subprime turmoil. Indeed, the contrast between the conditions in Mexico and those abroad is so striking that the Mexican operations of foreign financial institutions have come to the aid of their headquarters in recent months.

…to ease

A slowing domestic economy, along with a slowing global economy, should eventually provide Banco de Mexico room to ease. If we (and Banco de Mexico) are wrong and the downturn in demand in Mexico is even more severe, then there is increased scope for a rate cut sooner. That part is fairly straightforward: watch for signs of plummeting domestic demand that impede companies from passing on increased input costs to consumers or wait until a slowing globe eases input prices. But there are two other cases in which Banco de Mexico could surprise us with an easing move sooner than we have expected, that are not tied to a weakening economy. Both should be monitored carefully:

First, Mexico’s new alternative minimum corporate tax may prove to have a much smaller impact on consumer prices than the central bank initially estimated. Last year, Banco de Mexico estimated that the one-off impact from the new tax could add 0.4-0.5% to consumer price inflation in 2008. Based on central bank guidance and our initial calculations, we adjusted upward our model-based forecast of 3.3% inflation for 2008 to 3.8%. If the central bank’s calculations turn out to be excessive − as some from the finance ministry have suggested − then even if the economy does not suffer from a more pronounced slowdown than the one currently anticipated, Mexican inflation could end the year lower than our forecast or the range of 3.75-4.25% that the central bank is working with. Faced with the uncertainty over how important the impact would be, the central bank left its inflation forecast for end-2008 and the path during the year and for 2009 unchanged.

Second, Banco de Mexico could ease rates more quickly if the Mexican peso began to break out of its current range and strengthen sharply. The peso has been in a range of 10.70-11.20 for the past 18 months. A gain would likely trigger a lively debate at the central bank, with some arguing in favor of easing. Some might argue that the widening interest rate differential between Mexico and the Fed is attracting speculative inflows and point to the currency’s gain as evidence. Others might argue that the strengthening peso is, in effect, producing a tightening in monetary conditions, and that it is time for the central bank to revisit the right mix between interest rates and the currency.

While the notion of a monetary conditions index (MCI) is relatively straightforward − in relatively open economies, both the real interest rate and the real effective exchange rate are important transmission mechanisms of monetary conditions to the overall economy − in practice, they are a bit more challenging to produce. Nonetheless, our own work on MCIs suggests that if the peso were to strengthen to 10.40 by year-end, that would represent a significant tightening in monetary conditions.

What could drive the peso stronger? Topping our list of candidates would be either a view that the US downturn was ending, or that a significant breakthrough on the energy reform front was at hand. Either of these events could not only spark gains in the currency, but also prompt − indirectly − a cut in interest rates.

Bottom line

For more years than we care to remember, we have been arguing that Mexico does not have an inflation problem. Mexico does, however, have an inflation-targeting problem. The target set by Banco de Mexico of 3% has only been achieved in one brief period − and even then it was driven by a temporary bout of produce deflation. Given the turmoil last year as Banco de Mexico struggled amid rising food prices to regain control over its message of commitment to its 3% target, we suspect that the central bank will be in little hurry to ease quickly in 2008. We are not arguing that Banco de Mexico can march to its own beat − the links with the US economy rule out any long-term monetary ‘decoupling’. But we would warn against confusing where Mexico’s monetary policy will ultimately end up with an argument over timing.

By Gray Newman New York
Morgan Stanley
February 06, 2008