By Konstantinos Venetis
Mexico’s central bank (Banxico) surprised markets this month, implementing a ‘one-off’ 50 basis point cut in the overnight interest rate to a record low of 3.00%. Banxico's accompanying policy statement cited a deteriorating domestic growth outlook as the basis for its decision. This much should come as no surprise. Less than a month ago, the central bank brought its forecast range for the rate of GDP expansion in 2014 down by 0.7 percentage points, to 2.3%-3.3%. And this revision came before data showed the economy grew at a mere 1.8% in the four-quarters to 2014 Q1.
Mexico's GDP growth has been held down by a combination of domestic and external factors this year, on the heels of a disappointing 1.1% GDP growth rate for 2013 as a whole. On the one hand, a ramp-up in government expenditure has so far failed to offset the adverse effect of a tougher tax regime, introduced at the start of 2014, on private demand and on confidence. Investment remains weak, hampered by structural bottlenecks; and the construction sector continues to act as a drag on overall activity, impacted by recent changes in housing policy. On the other, cold winter conditions in the US - the country's largest trading partner by a wide margin - have meant lower demand for Mexico's manufacturing exports.
Against this backdrop, Mexico's central bank now expects GDP growth in Q2 to be more moderate than previously anticipated, and continues to see the risks as skewed to the downside. On the central bank's own calculations, output is currently some 2% below potential. The gap has widened steadily over the past year, and is not expected to close until late 2015 or early 2016.
As such, inflationary pressures should remain contained for some time, consistent with Banxico's outlook for headline inflation staying below 4% this year and hovering slightly above 3% in 2015. In this regard, CPI was 3.5% in the twelve months to May - a reduction of 0.3 percentage points compared to the reading for April. Core consumer price inflation is running at just 3.0%, and market-implied inflation expectations remain well-anchored. Rather than being indicative of a change in Banxico's reaction function, or constituting a hit to its credibility, we view this as a judicious move in the direction of providing a much-needed tactical boost to growth - the domestic macro backdrop is likely to remain unsupportive for GDP, at least in the short term. On the domestic front, Mexico is pushing through with sweeping structural reforms, which should eventually reduce its dependence on oil revenue while boosting its potential GDP by attracting FDI and enhancing labour productivity - still low by international standards. But these will take time to bear fruit. Banxico has lowered its policy rate by a cumulative 150 basis points since last March, despite CPI being above its target of 3%, for good reason.
Moreover, this seems like a particularly well-timed decision. First, it makes sense in terms of reinforcing the emergence of 'green shoots' in beaten-down private sentiment - consumer confidence continued to improve in May and the PMI manufacturing survey confirmed a pickup in momentum, consistent with the message from the latest trade data. Second, Banxico took advantage of what are still relatively benign global financial conditions; it is much easier to justify a negative real policy rate when the Fed's monetary settings and rhetoric are still in tapering mode. Third, from a risk management perspective, governor Carstens has made a calculated bet with a good margin of safety attached to it. On the one hand, if US yields normalize quicker than currently envisaged, Banxico has allowed itself more room to hike rates - whether with a view to putting a floor under the currency or managing the impact of a stronger-than-expected US recovery on the domestic GDP/inflation mix. On the other hand, should US growth disappoint in the coming quarters, Mexico's central bank has bought valuable insurance by acting pre-emptively.
We view Banxico's surprise decision to cut rates this month as a timely move with an attractive risk-reward profile. It is prudent to lean against a subdued growth outlook while the opportunity cost of a potential sustained pickup in inflation seems rather low.
Disclosure: The author has no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.
Business relationship disclosure: Alpha Now at Thomson Reuters is a team of expert analysts that are constantly looking at the financial landscape in order to keep you up to date on the latest movements. This article was written by Konstantinos Venetis, independent commentator and analyst. We did not receive compensation for this article, and we have no business relationship with any company whose stock is mentioned in this article.