Agustin Carstens, governor of the Bank of Mexico, has been in favour of an interest rate cut for some time.Dave Chan/The Globe and Mail
Mexico's central bank cut interest rates on Friday for the first time in nearly four years, taking borrowing costs to a new record low as policy makers bet they are winning the battle against inflation in Latin America's second-largest economy.
The cut was a bold move by the central bank as inflation has begun to quicken and consumer prices are expected to climb in the coming months. Analysts say policymakers risk losing their hard-won credibility if price pressures do not soon fade.
The Banco de Mexico cut benchmark borrowing costs by 50 basis points to 4.0 per cent, a move predicted by only five of 21 analysts polled by Reuters last week.
Although policy makers had said at their last meeting that looser policy was possible if both slower growth and inflation continued, most had not expected the central bank to act so quickly.
The move surprised markets and most analysts who have watched the central bank hold its key rate steady since mid-2009 and back away from previous signals that it might tweak borrowing costs in either direction.
"This change recognizes the success in the medium term in bringing down inflation and will help the economy adjust to a scenario of lower economic growth and inflation," the central bank said in a statement, noting that the cut was not the start of a cycle.
The statement made it clear the cut is a one-off move aimed at bringing Mexico into line with easy money policies in major economies. It also reflects the central bank's view that inflation is on a steady downtrend toward its 3-per-cent target, after making a structural break from past years of price pressures.
Mexico's peso whipsawed on the decision, briefly weakening before surging to a session high. Analysts said the fact that the cut was seen as a one-time event should not erode support for the currency.
Yields on short-term interest rate swaps fell after the decision as many had not tipped a cut so soon, while bond yields rose as investors who had been betting on a cut took profits.
"This was not completely priced in. It is a good move by the central bank, it is a recognition by the central bank that is has been successful on inflation," said Alonso Cervera, an economist at Credit Suisse in Mexico City.
Policy makers shrugged off a quickening in the inflation rate to 3.55 per cent in February and said slow growth and continued slack in the labour market would help keep prices in check.
The central bank said inflation is expected to tick up further in coming months to 4 per cent before falling back to around 3 per cent by the second half of the year. It is then seen holding around that level next year.
"If in the next three, four or five months inflation falls and converges to 3 per cent, the action of the bank will sit well and they will not lose credibility," said Ezequiel Aguirre, a strategist at Bank of America in New York.
"The problem is if this does not happen. It is too early to make the final judgment," he added.
The decision was also a response to foreign investment inflows, which have poured into Mexico due to its relatively high interest rates. Those flows could strengthen the peso and effectively tighten monetary policy in Mexico, whether the central bank wants it or not.
The Banco de Mexico famously has a hands-off approach to the peso currency and markets, unlike many of its emerging market peers. But it is still concerned about stock and bond inflows which totalled $80-billion (U.S.) last year, and hopes that a lower rate of return will give investors pause.
Mexico's economy is seen slowing this year to 3.5 per cent growth from a 3.9-per-cent expansion in 2012, and the sharp slump in exports and retail sales at the start of the year had fanned concerns about the impact of weaker U.S. growth.
The central bank said the main risk to growth in the short term was spending cuts in the United States, which buys 78 per cent of Mexico's goods exports.
The cut, the first decision under a new composition of the Banco de Mexico board, is the culmination of a case Governor Agustin Carstens has been making since his appointment in 2010.
Then, he argued that rock-bottom rates in major economies had created a low-inflation atmosphere where Mexico could cut credit costs without stoking prices. In early 2012, the central bank also signalled it would like to lower rates.
But both times the flirtation with a cut was stifled by global market turmoil hammering the peso and threatening to fan inflation through higher import prices.
Mr. Carstens may have been aided in his arguments this time by new board member Javier Guzman, who replaced Jose Sidaoui, seen as one of the board members most concerned about inflation.
The Banco de Mexico did not say whether the decision was unanimous – information that will come with the release of the meeting minutes in two weeks – but deputy governor Manuel Sanchez had urged caution on declaring inflation under control.
"To a certain degree, Mr. Carstens is trying to realign with all the rate cutting that is occurring across the line of central banks. He's effectively thrown himself into that mix with other rate cutters," said Enrique Alvarez, an analyst at IDEAglobal in New York.