The Bank of Mexico unexpectedly raised its overnight rate to 3.75% yesterday in a bid to support its weakening currency. The timing of the rate rise was a surprise to markets. The inflation situation and state of the domestic economy is still favorable enough to continue normalising rates, mainly in the context of steep peso depreciation.

However, the Bank of Mexico's response to the decline of its currency was late as the peso did not positively react to the earlier liquidity measures. The central bank's decision to raise rates came in spite of the falling prospects of Fed's continued rate hike in 2016. Therefore, this can be totally linked to the continued pressure on peso. At this point, the inflation and domestic economy situation was barely going to be a topic for worry. It was also certain that the depreciation of peso would ultimately increase inflation expectations.

"The rate hike is still broadly consistent with our year-end rate forecast of 4.25%, but it also means that bulk of rate hikes will be frontloaded (we earlier expected a 25bp hike in each quarter this year). That being said, the policy tightening (fiscal and monetary) will likely affect growth prospects over the medium term", says Societe Generale.

There is a likelihood that the Bank of Mexico will consider raising rates further in the next couple of meetings unless the oil prices rebound significantly or the economy deteriorates. However, this might not be a good enough reason for the central bank to not hike rates further.

Meanwhile, the Mexican government stated that it will reduce spending by MXN132bn, which is around 0.7% of estimated 2016 nominal GDP, due to the increasing threat of fiscal deterioration after the further drop in oil prices. However, the government has delayed in taking this decision. Part of it had already been factored into several projections, although with the likelihood of a higher fiscal deficit. Almost 75% of the total reduction is likely to fall on the spending plan of Pemex. Moreover, this is expected to impact their proposed investment spending too, mainly in the mining sector.

"Overall, the cut in spending could shave nearly 0.3pp from growth (via direct and indirect effects) this year and nearly 0.2pp next year (via indirect effects)", says Societe Generale.