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Mexico's central bank meets today. No change in the 4.5% policy rate is likely. The economy is just emerging from the worst recession in modern times, with a 6.5% contraction last year. Price pressures are rising, but the increase from 4.46% in January to 4.83% in February appears to largely reflect increases in administered prices, like gasoline, and tax hikes. The central bank expected inflation to be between 4.25% and 4.75% in Q1.

There are two other issues that may be more important to the near-term outlook for the peso. Most importantly, the new finance minister, who also heads up the government's currency commission, has indicated that his ministry is considering boosting its dollar purchases. Currently through an auction of options, it essentially buys $600 mln a month. It is not clear when and by how much this could increase, but a decision is expected in the coming weeks and there is talk it could increase to $800 mln to $1 bln.

The main goal is to increase reserves, which now are just below $95 bln. Recall that during the crisis, Mexico had to dip into its reserves and received a standby credit facility from the IMF, which was just renewed. The lesson Mexico drew from the crisis, as did other developing countries, is that a large reserve cushion is a type of self-insurance. In effect, just as the liquidity preference for individuals and business appear to have risen by the experience of the crisis, so to did the liquidity preference for sovereigns increase and this is expressed via reserve accumulation.

The likely increase in dollar purchases appears to have tempered the enthusiasm for the Mexican peso which yesterday week reached a 16-month high against the dollar (USD dipped below MXN12.43). Although we have been skeptical about the peso's legs, the attraction of Mexico is based on 1) its proximity to the US and should benefit from stronger growth in its NAFTA partners; 2) the healthier auto sector in particular had been cited by some; and 3) relative high yields and a ostensibly more stable than many of the alternatives. We have thought there were faster horses in the region, like Brazil and Chile and while they were better performers earlier, the peso has caught up in recent weeks.

The second development that is overshadowing the low expectations going into central bank meeting is another tip by Finance Minister Cordero. He indicated that the government is likely to revise up its growth forecast again in the coming weeks. Recall that the 3.0% forecast at the start of the year was raised last month to 3.9%. The revision could lift the forecast toward 4.25%.

The larger the dollar purchase increase, bigger the pullback the peso may experience. The more aggressive the program the larger the protest of peso strength will be perceived. However, the peso's strength is just providing an opportunity for Mexico to do what it wants and that is to build up its reserves even more. The larger the GDP revision, the quicker the market may expect the output gap to be closed and more likely a rate hike will be delivered later this year.

The US dollar has declined about 4% against the peso during the last leg down which began on Feb 24 near MXN12.95. The uncertain policy environment has helped the greenback find support near MXN12.43. Initial resistance is being tested near MXN12.55, but there is potential toward MXN12.62. Sentiment toward the peso remains constructive, though our concerns about the political stalemate on fiscal reform, broader competitive issues and the ongoing high level of violence persist.

Disclosure: None

Source: Mexico's Central Bank Meeting Friday Overshadowed by Other Issues