This Thursday, Banco de México (Banxico) will announce its first monetary policy decision of the year. The market has totally discounted that the central bank will continue with the current cycle of hikes, which began in June 2021 and has taken the funding rate from 4.0 to 5.5 percent.
However, the market’s attention is focused on the magnitude of the increase and possible clues about the future trajectory of increases. Specifically, specialists debate whether Banxico will increase the rate by a quarter of a point or by half a point.
In the most recent Citibanamex analyst survey, published on January 20, 18 of the 30 analysts surveyed anticipate a half-point increase while the other 12 expect a quarter-point increase. This represents a change from the previous survey in which 12 of 28 respondents were betting half a point and 16 betting a quarter point.
The increase in the number of specialists who now anticipate an increase of half a point has to do with two main factors. The first is that inflation expectations for 2022 continue to be revised upwards. The second, and more relevant, is that the Fed has confirmed that its monetary policy normalization cycle will begin in March with a first increase in the funding rate and with the conclusion of the liquidity injection program.
Likewise, the market has been incorporating a more accelerated cycle of hikes by the Fed, which could mean between four and six increases in the funding rate during 2022. Additionally, specialists now expect the Fed to begin to reduce the size of its balance between the second and third quarters of 2022.
Despite the fact that the Mexican economy is in full stagnation and that the growth outlook for 2022 and 2023 is not very encouraging, Banxico must send a strong signal that it is committed to fulfilling its unique mandate: price stability.
Although it is true that inflationary pressures in Mexico do not come from an overheating of demand and that part of the inflation is imported, it is also true that a deterioration in the exchange rate could contribute to greater inflationary pressures.
In an environment in which the Fed is in the process of normalizing its monetary policy with higher rates and liquidity withdrawals, the dollar should have a tendency to appreciate, especially against emerging market currencies.
To avoid a scenario of greater depreciation of the peso against the dollar, it is necessary for Banxico to follow the Fed with its hike cycle so that the rate differential does not widen too much. It is worth remembering that in mid-2019, when the reference interest rate set by the Fed in the United States was 2.25%, Banxico’s funding rate was 8.25%, equivalent to a spread of six percentage points in a low inflation environment.
If we anticipate that the Fed will raise its rate between four and six times this year, to place it between 1.0 and 1.50%, Banxico could be forced to raise the rate from 5.5% to at least 7.25 percent. Also, the last time that inflation in Mexico was close to current levels, in mid-2017, Banxico’s funding rate was 7.25 percent.
Additionally, at the end of 2018, the last time year-end inflation was at a level above 4.5% – not very far from what is expected for 2022 – the funding rate was 8.25 percent. Although the vote is likely to be split, an increase of less than half a point could be counterproductive in terms of credibility for Banxico.
Given the new composition of its Governing Board, Banxico would do well to send a strong signal of independence and commitment to its unique mandate, beginning with a half-point increase in the funding rate in this week’s decision.
Socio Director de EP Capital, S.C.
Joaquín López-Dóriga Ostolaza is Managing Partner of EP Capital, SC, a consultancy specialized in mergers and acquisitions founded in 2009.
He is a graduate of the Bachelor of Economics from the Universidad Iberoamericana, where he graduated with honors and the highest average of his generation. He has a Master’s degree in Economics from the London School of Economics, where he was distinguished with the British Council Chevening Scholarship Award.