Itaú BBA - Resuming the tightening cycle

Scenario Review - Chile

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Resuming the tightening cycle

January 11, 2018

Higher-than-expected inflation is putting pressure on the Central Bank

Please see the attached file for all graphs.

• Banxico resumed the tightening cycle in December (hiking 25-bps, to 7.25%), after staying on hold for the past three meetings. The guidance in the statement suggests another rate hike in February is likely. We expect the policy rate to peak at 7.5%. 

Given the recent supply shocks in non-core prices and stronger-than-expected inertia, we have revised our inflation forecast for 2018 to 3.7%, from 3.3%. Still, our forecast remains consistent with a meaningful disinflation (from 6.8% in 2017), driven by lower exchange-rate pressure (we see the peso at 18.5 to the dollar by the end of this year) and normalization of non-core inflation (energy and non-processed food). 

We expect GDP growth of 2.1% for both 2017 and 2018, down from 2.9% in 2016, and a moderate acceleration to 2.4% in 2019. While uncertainty over NAFTA and economic policies post-elections is a drag on investment, strong U.S. manufacturing performance, a still-solid labor market and recovering real wages are buffers. 

Our forecasts are subject to a high degree of uncertainty. They are based on the assumption that NAFTA will continue and economic policies will not change meaningfully after the presidential elections. If these assumptions do not hold, a scenario with lower growth, weaker currency, higher inflation and tighter monetary policy is likely.

Central Bank takes hawkish turn

Mexico’s central bank increased its policy rate by 25-bps in the last meeting of the year, as expected by us and an almost evenly split consensus (according to Bloomberg, a large minority expected the policy rate unchanged). Thus, Banxico resumed the tightening cycle after a pause that lasted for the previous three meetings. In the statement announcing the decision, the board highlights that the outlook for inflation has become more challenging, given the pressures on the currency coming from the Fed’s monetary policy decisions and NAFTA renegotiation, besides the higher-than-expected inflation prints. In this context the board considers that the balance of risks to inflation has deteriorated, and felt necessary to increase the policy rate. The decision was split, with one board member voting for a larger 50-bp rate increase. 

Importantly, the last paragraph of the statement ends with a more hawkish sentence than in the previous meeting, as the board mentions the intensification of risks for the inflation outlook and pledges to take – if needed – “corresponding actions as soon as necessary” to ensure inflation expectation anchoring and inflation convergence to the target.

Considering risks related to NAFTA, U.S. monetary policy and presidential elections; the higher-than-expected inflation readings; and, of course, the clear hawkish tweak in recent communications we expect a 25-bp rate hike in February (to 7.5%). While we expect the policy rate to peak at 7.5% in 2018, the risks are clearly tilted towards more rate hikes. Assuming risks dissipate, we expect the board to deliver two 25-bp rate cuts in the second half the year, taking the reference rate back to 7% (and further down to 6% in 2019).

Inflation subject to new supply shocks

Inflation was pressured by more supply shocks in the last two months of 2017. The spike of the liquefied petroleum gas price (not smoothed out through excise tax adjustments, unlike gasoline) – driven by higher international prices and a weaker Mexican peso – coupled with big increases for a few non-core food items (mainly tomatoes and eggs) exerted significant upward pressure in November and December. Moreover, the minimum wage hike (10.4%) entered into force in December, in contrast with the customary practice of implementing it on the first day of each year. Against this backdrop, annual inflation reached 6.8% in December (from 6.6% in November), while core inflation stood broadly unchanged at 4.90% during the same period. Within the core index, core goods (tradables) stood at 6.2% and core services ran at 3.8% (both unchanged with respect to November). Turning to non-core inflation (12.6%, 12% previously), the large increase was explained both by higher energy prices and by agricultural items. 

While inflation at the margin is running much lower than the year-over-year figure, prices also picked-up speed on a sequential basis. On seasonally-adjusted terms, inflation accumulated in three months reached 5.36% (annualized) in 4Q17, compared with 4.1% in 3Q17. The pick-up was broad-based. 

Given the recent evolution of inflation and the resulting inertia, we have revised up our inflation forecast for 2018 (to 3.7%, from 3.3%). Still, our forecast remains consistent with a meaningful disinflation (from 6.8% in 2017), driven by lower exchange-rate pressure and normalization of non-core inflation (energy and non-processed food). For 2019, we see inflation at the 3% target.

Growth likely rebounded in 4Q17

Domestic demand slowed down meaningfully in 3Q17, battered by the natural hazards. The growth of domestic demand weakened to 0.9% qoq/saar (from 1.9% in 2Q17), with private consumption – the engine of activity throughout 2017 – expanding at a less vigorous pace (2.7% qoq/saar, from 3.4% in 2Q17). Fixed investment fell by 1% qoq/saar in 3Q17 (from a 1.3% contraction in 2Q17), with private investment (-1.3% qoq/saar, 1.9% previously) underperforming public investment (3.5% qoq/saar, -8.7% previously). Exports were also hit in 3Q17.

Data available for 4Q17 shows the economy is recovering, as expected, after the transitory hit it underwent in the previous quarter. The monthly proxy for GDP (IGAE) gained 0.11% between September and October, lifted by a 0.4% increase in Service output. Nominal manufacturing exports (measured in U.S. dollars) were up by 4.9% qoq/saar as of November. 

We expect GDP growth of 2.1% for both 2017 and 2018, down from 2.9% in 2016, and a moderate acceleration to 2.4% in 2019. Factors playing against economic growth in the short-term are tight macro policies (fiscal and monetary) and uncertainty over policy direction after the elections and trade relations with the U.S. However, we note that fiscal drag will be smaller in 2018 relative to 2017. More importantly, a dynamic U.S. industry will likely sustain Mexico’s exports (also considering the competitive exchange rate). Finally, the solid labor market and the expectation of lower inflation support consumption.

Twin deficits narrowing

The trade deficit is narrowing as the effects of natural hazards (hurricanes and earthquakes) dissipate. At the margin, both the energy and non-energy balances improved substantially. The seasonally-adjusted 3-month annualized deficit narrowed to USD 11.2 billion (from USD 17.2 billion in October), as the same measure for the energy deficit and non-energy surplus posted USD 20.7 billion (from USD 22.3 billion) and USD 9.6 billion (from USD 5.1 billion), respectively. This is consistent with a low current account deficit (we expect 1.6% of GDP this year and 1.7% in 2019).

On the fiscal side, the deficit is also narrowing amid rising revenues and falling expenditures. The recent increase of oil prices is boosting revenues, while fiscal consolidation continues running its course with the government slashing spending (especially investments in physical capital). In fact, even if 70% of the amount of the windfall dividends sent by the Central Bank to the government are excluded (as the remaining 30% is directed to stabilization/sovereign funds, and therefore recorded as both revenues and expenditures), the 12-month rolling primary balance reached a MXN 129 billion surplus in November (0.6% of GDP, according to our calculations), from a MXN 107 billion surplus at the end of 3Q17. Likewise, using the same metric (ex-dividend), the 12-month nominal fiscal deficit narrowed to MXN 380 billion (1.7% of GDP), from MXN 414 billion in 3Q17. Public debt to GDP ratios also continued trending down, with net debt posting MXN 9,550 billion in November (43.6% of GDP, according to our calculations, from 44.1% of GDP in 3Q17) and gross debt at MXN 10,159 billion (46.3% of GDP, from 47.2% of GDP in 3Q17). 

Political landscape taking shape

The most recent polls show Lopez Obrador (AMLO) still leading the presidential race by a significant margin. Since December, unlike in the previous months, the political chessboard underwent a crucial change, as it finally became clear who would be the presidential candidates running under the banner of the main political forces; AMLO for Morena, José Antonio Meade for the ruling party PRI (stepping down as Finance Minister in early December), and Ricardo Anaya for the PAN-PRD right-center-left alliance (officially announcing his candidacy in mid-December). Former first-lady Margarita Zavala will likely run as independent. Taking an average of four pollsters that we track (El Financiero, Reforma, Mitofsky, and El Universal), AMLO led the race as of December (31% of vote intentions, from 32% in November), followed by Ricardo Anaya (23%, from 20.3%), José Antonio Meade (16%, from 17.7%) - who still has very low name recognition and will likely improve in coming months as the PRI deploys its well-organized political machinery – and Margarita Zavala (10% vs. 11.3% in November).

2018 begins with Mexico more willing to compromise on NAFTA

The last NAFTA meetings of 2017 marked progress on a number of non-controversial topics, dispelling the perception of deadlock, but did not address the issues that could potentially cause the negotiations to fall apart. The next NAFTA round – to be held in Montreal on January 23-28 – will be critical as it will give more clarity on whether it is feasible to conclude negotiations by March 2018 (target according the trilateral press statements) and thus avoid the overlapping of the NAFTA talks with Mexico’s presidential race.

Mexico’s Head Negotiator – Ildefonso Guajardo – signaled that Mexico might be willing to offer more substantial concessions to the US at the 6th round. These concessions would come for two of the most thorny issues: dispute settlement and rules of origin. On dispute settlement, Guajardo said that there is a possibility for “opt-in and opt-out on Chapter 11” (which is one of the U.S. key demands). Specifically, NAFTA’s Chapter 11 contains an investor-versus-state dispute settlement mechanism whereby private investors can bring cases to arbitration panels and obtain retroactive compensation. With this “opt-in, opt-out” proposed clause, if a private party presents an arbitration claim within the framework of NAFTA, then the defendant (government of US, Mexico, or Canada) would have the option to be subject to the arbitration process (opt-in) or refuse to participate (opt-out). Finally, on rules of origin, Guajardo stated that “the solution is, without doubt, a strengthened regional content rule in for the auto sector”. 


João Pedro Bumachar
Alexander Muller

Please see the attached file for all graphs. 

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