MexECON Blog

Central Bank Surprises, Slashing Rates to 3.00 Percent

Policymakers at Banco de México unexpectedly slashed their benchmark interest rate to 3.00%, after holding it steady at 3.50% since last October.  The cut was the biggest since the initial move in the current cutting cycle, which began in March 2013.  In their statement, the policymakers said international financial markets had stabilized recently.  Based on the main central banks' promises to continue supporting the markets, they also felt that capital would continue to flow into Mexico and the other emerging markets.  At the same time, the policymakers said that the modest rebound in Mexican exports in recent months had been outweighed by continued weakness in domestic demand.  In fact, they admitted that economic growth this year was likely to be even weaker than expected just a couple of weeks ago, when they cut their 2014 growth forecast to a range of 2.3% to 3.3%.  Finally, the policymakers said that falling inflation pressures gave them scope to cut rates in support of the economy.  However, the policymakers stressed that they did not expect to cut rates any further, and, with policy settings at their current level, they felt confident that inflation would still continue to moderate and eventually fall to their goal of 3.0%.

Comment:  The Mexican economy posted a strong recovery from its 2008-2009 recession, with gross domestic product (GDP) growing at an average rate of 4.3% from 2010 to 2012.  Since then, however, the economy has slowed dramatically, and GDP growth in 2013 came to just 1.1%.  The pent-up demand and post-recession inventory rebuilding that fueled the initial recovery have long since petered out, as would be expected in any economic cycle.  Continued weakness in the U.S. economy has also put a lid on Mexican exports.  Just as significantly, however, domestic demand in Mexico has faced a number of challenges, including tightened government spending after the inauguration of President Enrique Peña Nieto at the end of 2012 and a change in government housing policy that continues to limit homebuilding.  These headwinds have weighed on hiring and kept unemployment from falling rapidly, but the consumer has also been discouraged by bouts of inflation and the imposition of new sales taxes at the beginning of 2014.  I have therefore been warning for some time that Mexican economic growth was likely to remain relatively weak for the time being.  With their large, unexpected rate cut on Friday, it appears that the policymakers at Banco de México now have the same worry.  The question is how effective their latest rate cut will be.  Recently, there have been some signs that the economy is already stabilizing, and the rate cut could add a bit of fuel to the nascent recovery.  That would be especially true if the rate cut weakens the peso and promotes stronger exports.  Nevertheless, the domestic challenges seem relatively entrenched.  I believe that they will continue weighing on the economy, perhaps until there is a more robust acceleration in exports.  In a worst case scenario, domestic demand could remain fragile until the government's economic reform program begins to show tangible benefits.

Patrick Fearon, CFA
Vice President, Fund Management

Benchmark Rate 1406

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