Mexico: Setting The Stage For Rate Cuts

Inflation has, for two years now, forced Mexican policymakers to adopt a deeply hawkish monetary policy stance. But as inflation drops to the lowest level since 2016 this Thursday, amid persistent weakness in economic activity, the case for policy easing should strengthen. Our revised inflation path suggests rate cuts could start sooner than expected.

Deceleration in economic activity increased the urgency of monetary easing …

The main highlight of the 4Q18 Quarterly Report released by the central bank last week was the sharp drop in the bank’s forecast for GDP growth. Banxico’s 2019 GDP growth forecast dropped 0.6ppt and is now centered at 1.6%, in line with our own forecast. 2020 forecasts were lowered by 0.3ppt, centered at 2.2% now. 

The adjustment follows disappointing results in a broad range of indicators in recent months, including industrial, retail and investment activities, unemployment and bank lending. It is also consistent with falling market expectations for economic activity, which intensified since the election of Lopez Obrador in last year’s Presidential election. 

According to the central bank monthly survey, 2019 GDP growth forecasts dropped 70 basis points in the past 9 months, from 2.3% to 1.6% now.

Banxico also now estimates that the output gap (for the non-oil sector) has become negative and is going to continue to widen in the foreseeable future, as GDP growth remains below potential.

… which could gain traction amid a faster-than-expected drop in inflation

The central bank’s inflation forecasts have not changed much in recent months. Compared to the previous quarterly report, the most noticeable change is seen in the long-end of the forecasted range, 2H20, when inflation is now forecasted to drop below the 3% target.

The bank still expects the yearly inflation rate to re-enter the 2-4% targeted range in 3Q19, after trending slightly above 4% throughout 1H19. But the February inflation print to be released on Thursday could already show headline inflation at the 4.0% edge of that inflation-targeting range for the first time since December 2016, down from 4.4% in January. And our own forecast suggests that inflation could drop below 4% already in 2Q, increasing the risk of a sooner-than-expected improvement in inflation dynamics.

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