Mexico: No Hike, No Comfort (March 20, 2007) By Gray Newman
No Hike, No Comfort
March 20, 2007
By Gray Newman | New York
When Mexico’s central bank meets this week, we expect it to keep interest rates unchanged. More importantly, however, we expect it to back away from the rigid rule it put in place in its February 23 communiqué and replace it with new hawkish language giving it maneuvering room to hike in the future. The March communiqué — set for release this Friday — is unlikely to resolve the debate in the market on whether Banco de Mexico will be prompted to hike this year, but it is likely to push out the date of any possible hike.
We maintain our forecast of no hike in interest rates in Mexico in 2007 and still expect interest rates to have room to fall in 2008, but concede that Mexico watchers are unlikely to be given much comfort that our forecast of the rate path is the correct one. Both the inflation readings in the months to come and the central bank’s statements are likely to keep the debate over interest rates alive at least through the third quarter. That does not mean we cannot have positive reports with lower-than-expected readings; indeed, that could take place this week. Only that the improvement on the inflation front in Mexico is likely to be bumpy, with conflicting signals between core and headline and between month-over-month and year-over-year readings.
Reversing the February rule
The February communiqué was one of the most unfortunate statements made by Banco de Mexico in recent memory, in our view. The communiqué issued an ultimatum: either core inflation would begin to show a reversal in March in both year-over-year and month-over-month terms or the central bank would move to hike interest rates (see “Mexico: Banco de Mexico’s Ultimatum” in This Week in Latin America, March 5, 2007).
We suspected that Banco de Mexico never intended to jettison its long-stated focus on whether the current transitory uptick in inflation was beginning to contaminate wage agreements, inflation expectations or other prices. Instead, we suspect that the central bank wanted to accomplish two things in February:
• First, Banco de Mexico wanted to send a strong signal that interest rate cuts were now out of the picture. In January, the central bank first suggested that a hike could be necessary, but the language was almost a line of central bank boilerplate that simply stated that the central bank would act if it needed to. The February statement was designed to prepare the market in the event that a hike was needed. Recall that the central bank has been sensitive to concerns that it may have mislead the market with its relatively benign statements in November and December, which did not suggest the sharp uptick in inflation that took place in January.
• Second, the central bank wanted to signal that the longer inflation remained significantly above its targets, the greater the risk that expectations, wages and other prices could be contaminated. We suspect that the February communiqué was meant to convey that Banco de Mexico would not necessarily have to wait until wages or medium-term expectations or other prices began to move up to act. The central bank was trying to avoid a rigid rule limiting when it could hike rates. But by avoiding that rigid rule, it set itself up for a much more rigid precept that, if read literally, was even worse: the February communiqué risked shifting attention away from what really should drive central bank policy, namely whether the current supply shock was threatening the medium-term trend of inflation. In addition, it introduced an artificial deadline. If other prices, wages or expectations began to show a worrisome trend, we’d expect the central bank to consider acting regardless of what happens to March’s core readings. And, alternatively, if Mexico suffered an unexpected supply shock in the second week of March which monetary policy is particularly unsuited to deal with, we’d hope that monetary policy wouldn’t be on autopilot, forcing the central bank to hike rates.
Banco de Mexico’s statement on March 23 is likely to contain three elements. First, we expect it to note that core inflation is showing an improvement in the first half of March, but to warn against extrapolating from such limited data. Second, we expect the central bank to argue that it will continue to watch core carefully in the months to come and will remain ready to act if deems it appropriate — either because some contamination is being seen or because it fears that such contamination is likely. Finally, we expect the central bank to note that the Mexican economy is slowing sooner and at a somewhat more pronounced pace than the central bank thought at the beginning of the year.
While the statement on a slowing economy might provide some relief to those worried that Banco de Mexico is ready to act, that comfort is likely to be offset by the statement that the central bank reserves the right to act in the months ahead even if it does not see any contamination. The risk of contamination may be enough to provoke Banco de Mexico to move.
The good news on Mexico’s inflation front is that we are not seeing any generalized pressures on prices. Medium-term expectations remain well-anchored, other prices have not suffered an uptick and wages remain consistent with a move towards the target of 3% inflation. This past week, one of the most contentious wage negotiations ended with the electricity workers union accepting a 4.25% increase in wages. While you can debate what the pace of productivity growth is within Mexico’s electricity sector, there is little doubt that with modest productivity growth in the broader economy, a 3% inflation target is not put in jeopardy by wages growing near 4%.
Our concerns are two-fold: while core is likely to improve in the months to come, the path is likely to be bumpy; and headline readings could easily move above 4.5% and closer to 4.6% or 4.7% in May, June and July before turning down. Of course, much of the uptick is due to little more than a difficult base of comparison, and should not matter. Still, it is likely to attract attention and provide cause for concern at the central bank. After all, with a bumpy core and high headline year-over-year numbers, there is some risk that they could begin to contaminate expectations and wages. If enough economic agents think inflation is on the rise and act accordingly, it will likely turn up. We suspect that this will not be the case, in part because we see the economy slowing in 2007, which is likely to take off some of the pressure that was building last year.
We are much less concerned about inflation in Mexico than we are about the prospect for reforms to move forward. On that front, the authorities have made some progress this past week with a bill in congress with broad political support to stem the fiscal losses associated with Mexico’s ‘pay as you go’ public workers pension system. But while that is positive, we are concerned that convincing the broad policymaking class to take politically costly steps in other areas while facing an abundance of convergence inflows will be difficult. That, and not the temporary inflation scare at the beginning of this year, remains Mexico’s greatest challenge, in our view.