Itaú BBA - Tighter fiscal and monetary policies amid slower activity

Scenario Review - Mexico

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Tighter fiscal and monetary policies amid slower activity

July 6, 2016

We expect additional interest rate increases in Mexico in 2016 only if exchange-rate depreciation pressures return.

Please see the attached file for all graphs. 

• Economic activity is showing signs of moderation. The IGAE (monthly proxy for GDP) contracted sharply between March and April, after posting two poor readings. While the trend of retail sales remains strong, manufacturing exports weakened further. We now expect the GDP to expand by 2.1% this year (2.5% in our previous scenario) and by 2.4% in 2017. Besides the disappointment in recent activity data, our revision also takes into account the downward adjustments to our forecasts for the U.S. economy.  

• During the first half of 2016, the Mexican peso was one of the worst-performing currencies. As the Brexit vote generates more uncertainty in global markets, Mexico’s central bank decided to raise the policy rate by 50 bps in a bid to support the currency. The Ministry of Finance also announced further expenditure cuts for this year (by 0.2% of GDP). We continue to expect the peso at 17.5 to the dollar by the end of this year and the next. 

• Headline inflation remains below the center of the target. Core inflation is rising, pushed up by tradable prices (reflecting the peso weakening), but it continues around the center of the target. Our forecasts for activity and inflation are consistent with well-behaved inflation ahead (although higher than the current levels). We expect inflation at 3.0% by the end of this year and the next.  

• Considering that we see moderate growth, well-behaved inflation and no hikes by the Fed this year, we expect additional interest rate increases in Mexico in 2016 only if exchange-rate depreciation pressures return.

Improving the carry

Mexico’s central bank raised the policy rate by 50 bps at the end of June. The move was a response to the performance of the exchange rate, the key variable driving Mexico’s monetary policy decisions. The Mexican peso has been one of the worst-performing currencies in the first half of the year and also since May 5 (when the last monetary policy decision was held), in spite of the actions already taken by policymakers at the beginning of this year (a 50-bp hike in an extraordinary meeting, budget cuts of 0.7% of GDP and the pledge to intervene in the exchange-rate market if necessary).

In the statement announcing the decision, the central bank emphasized the financial risks related to Brexit. The central bank sees negative consequences of this event for global economic growth and for international financial markets.

The central bank’s stance on inflation is of greater concern. The central bank continues with its benign forecasts (around the center of the target in 2017 and slightly above that level by the end of this year), but it thinks that the balance of risks deteriorated (even though it also sees a worse balance-of-risks for activity).

In this context, the board sees the need to preserve macro fundamentals, and not only through monetary policy. Although the board praised the recent fiscal consolidation announcements (the Ministry of Finance announced a further 0.2% of GDP in expenditure cuts for this year, immediately after the Brexit vote, which are designed to show a firmer commitment to fiscal consolidation), it said more is needed, calling for a primary surplus from 2017 on.

In the concluding remarks of the press statement, the central bank continues to mention first the evolution of the exchange rate when listing the variables to be monitored for the next meetings. Also identical to the previous decisions, the interest rate differential with the U.S. and the evolution of the output gap are listed.

Importantly, in contrast with the February hike, the central bank did not say “the move is not the beginning of a cycle,” leaving the doors open for more.

In all, the most recent monetary policy decision together with the signals for the upcoming meetings are consistent with our forecast that the Mexican peso will end this year at 17.5 to the dollar. The commitment of Mexico’s authorities with the currency combined with the benign environment for emerging markets will likely lead to an appreciation of the exchange rate from the current levels.

In fact, we think the weakness of the Mexican peso is at odds with the country’s fundamentals. Mexico’s current account deficit is moderate (at 2.8% of GDP) and net external debt (considering foreign-currency debt only) is low (at around 10% of GDP). Although there are fiscal vulnerabilities, authorities are taking measures to correct the public deficit. The recovery of oil prices will also aid the fiscal accounts and at some point bring FDI to the country. Trump is a risk, but even if he is elected it is unlikely that he will be able to implement the anti-Mexico policies he campaigns on. Finally, the government has sufficient ammunition to protect the currency (real interest rates are still low, and there is ample room for intervention, given the size of reserves – USD 177 billion – and the flexible credit line with the IMF).     

Considering that we see moderate growth, well-behaved inflation and no hikes by the Fed this year, we expect additional interest rate increases in Mexico in 2016 only if exchange-rate depreciation pressures return.

Well-behaved inflation in spite of pressure on tradable prices

Headline inflation decreased, from 2.7% year over year at the end of May to 2.6% in the first half of June, entering its 14th consecutive month of below 3% inflation (central bank’s target). However, we note the upward pressure in core inflation, which increased from 2.9% to 3% during the same period. Prices for core goods are driving this increase, which is consistent with the exchange-rate weakness over the past months. Inflation for core services, in contrast, is more moderate, suggesting the absence of demand-side pressures.

Looking forward, we continue to expect inflation at 3% by the end of 2016 and 2017. In our view, firmer oil prices will likely put upward pressure on regulated prices by year-end, while the reversal of supply shocks (i.e., base effects related to the telecom reform) should also push the CPI up. Still, inflation would likely continue to be low versus Mexico’s historical levels. 

Activity slows

The economy weakened at the beginning of 2Q16. The IGAE (monthly proxy for GDP) contracted by 0.1% qoq/saar, the first negative rate since June 2013.

Industrial activity remains poor. It fell by 1.2% qoq/saar in April. Oil production remains an important drag, as highlighted by the 5.9% qoq/saar drop in mining sector activity. The fiscal consolidation is hurting Pemex’s budget and, consequently, its oil output. However, manufacturing production is also falling (by 1.3% qoq/saar), as exports remain weak (manufacturing exports declined by 12.4% qoq/saar in May).

The trend of retail sales is still robust in spite of a 1.4% month-over-month contraction in April. Retail sales grew 15.7% qoq/saar in April. Consumption in Mexico benefits from low inflation, strong formal employment growth, remittances (once converted to pesos) and credit.   

We have revised our forecasts downward for growth in 2016 (to 2.1% from 2.5% in our previous scenario) and in 2017 (to 2.4% from 2.7%). Besides weaker data at the margin, our downward revisions are also related to our new forecasts for the U.S (slightly lower than previously). Nevertheless, we still believe that a firmer pace of U.S. industrial activity – coupled with a moderation in private consumption – will likely mean more balanced contributions from consumption and exports to GDP growth in coming quarters. In fact, the U.S. ISM manufacturing has been above 50 since March and came in at a strong 53.2 in June, indicating that the drag of a strong dollar and oil investment on U.S. industry is fading. At the same time, temporary employment in Mexico – a leading indicator of overall employment – is growing at low levels, pointing to a less supportive labor market for Mexican consumers. Higher inflation will likely curb real wage growth too. Finally, the expected stabilization of the exchange rate means less impulse from remittances to consumption.


João Pedro Bumachar
Alexander Andre Muller


Please see the attached file for all graphs.  



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