Mexico: Cutting short the easing cycle

The balance of risks for Mexico’s post-pandemic outlook for economic activity remains skewed to the downside, with consensus expectations consolidating at a 2020 GDP contraction of -10%, among the worst in LATAM.

Despite this grim outlook and the rising output gap, central bank officials have refrained from replicating the aggressive rate-cutting cycle seen throughout LATAM in recent months. Moreover, the hawkish dissent seen at the last policy meeting, when one board-member (Irene Espinosa) called for a smaller rate cut of 25bp, presaged a growing discomfort with the consequences of the easing cycle.

Mexican policymakers appear more concerned than their LATAM peers about the incipient rise in food prices, which helped push headline inflation slightly above the targeted range in August (4.05% YoY).

Rising food prices was seen across the region, but it was generally downplayed by local policymakers, who tended to view the fact as the result of pandemic-related temporary supply constraints and changes in consumption patterns, with limited potential for lasting damage to inflation dynamics.

The rise in inflation expectations towards the upper-bound of the targeted range is more concerning, as it calls into question the credibility of the inflation targeting regime.

But, ultimately, Banxico’s enduring concerns regarding the impact of rate cuts over local market stability, which could be compromised if capital outflows surge, suggest that tolerance for additional cuts is likely very close to its limit. The assumption is that a sufficiently large Mexico/US rate differential is crucial to anchor local markets.

These factors suggest that this Thursday’s monetary policy meeting should conclude with policymakers slowing down the pace of rate cuts, to 25bp from 50bp, and emphasizing the reduced room for additional easing, when considering the rising price pressures seen in recent months.

We suspect officials will not explicitly signal the end of the cycle. But, at 4.25%, the tolerance for additional rate cuts would be considerably lower and would likely require significant improvements in the outlook for inflation and a stronger MXN. We now expect the cycle to end after this week’s rate cut, with the benchmark rate at 4.25%, instead of our previous call of 4.0%.

As we’ve discussed before, Banxico often cites Mexico/US interest rate differential as an important input in its reaction function, given its perceived impact over FX flows. As seen in the chart below, that differential should drop to 4.0% this week, or 175bp below the level prevailing in the recent 2017-20 period, which was marked by broad stability in non-resident holdings in the local government debt market.

Apart from the uncertainties generated by this narrowing rate differential, greater caution by central bank officials could also be justified by the recent rise in market volatility.

Even though the Mexican peso has been a clear outperformer over the past couple of months, the outlook for EM currencies appears cloudier now, amid heightened uncertainties regarding the global outlook for Covid-19 and economic activity, along with lingering concerns regarding the US fiscal stimulus and the November Presidential election.