Bank of Mexico to hike rates on peso pass-through and inflation normalization

The Bank of Mexico had hiked its rate by 50bp a few weeks after its February board meeting, proving that it was late to respond to peso’s depreciation. As the peso did not react positively to the liquidity measure, the central bank implemented the rate hike in spite of the decline in the prospects of continued hike by the Fed in 2016. The central bank’s decision can be totally attributed to the continued pressure on the currency.

While the inflation and domestic economy were hardly a source of worry, of growing concern was that the currency’s decline would eventually increase inflation expectations. The hike in February also implied that monetary tightening will take place despite moderation in growth outlook.

“This leads us to forecast a 25bp rate hike in March and another 25bp in Q2. Overall, we see a February rate hike still broadly consistent with our year-end rate expectation of 4.25%”, says Societe Generale.

The Bank of Mexico might still consider further rise in interest rates in 2016 unless the economy deteriorates of oil prices rebound significantly. An increase in oil prices might rebound the outlook for investment and can demand additional normalization of rates. In contrast to that, when the peso continues to be under pressure, it might become necessary for the central rate to hike rates given the pass-through concerns.

Moreover, in spite of downward revisions to near-to-medium-term forecast, growth numbers have usually surprised to the upside. In particular, service sector has grown at a strong pace, helped by rebound in real consumer spending. There is a continuous rebound in the labor market that should keep consumption growth strong. This might also lead to wage-push inflation unless investment activities decline. Overall, labor market, output and inflation trajectories are likely to support rate normalization in 2016. Additional slowdown in the US-led Mexican growth outlook poses downside risk to the rate outlook.