Analysis: Mexico central bank: closet currency warrior and inflation gambler

Fri Mar 8, 2013 6:14pm EST
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By Michael O'Boyle and Krista Hughes

MEXICO CITY (Reuters) - Mexico's surprise interest rate cut shows policymakers are worried that the peso could overheat in coming years, despite their hands-off attitude toward the currency in public.

The Banco de Mexico cut interest rates by 50 basis points despite rising inflation, a move that goes against orthodox arguments that lower interest rates can fan price pressures.

The central bank is staking its credibility that inflation in Latin America's second-largest economy has been tamed and will reach the bank's 3 percent target in the longer term, betting it can cut without putting pressure on prices.

Central bank chief Agustin Carstens is mindful of a potential acceleration in foreign investment in Mexico that could supercharge the peso and set the currency up for a painful slump once rates rise in advanced nations and flows reverse.

The reverse-engineered argument is about cushioning the economy now against the risk of a future currency shock that could upset even the most well-behaved inflation trend.

"If you lower the incentives to invest today, then the outflow will be lower in the future. So lower interest rates now mean lower inflation in the future," said Banorte-Ixe analyst Gabriel Casillas, who was one of the few to predict the cut.

"It is tough to see it since usually lower rates don't mean lower inflation."

Major economies around the world are tackling weak growth with unorthodox policies to boost money supply, with the Bank of Japan the latest to join the so-called "currency wars."   Continued...

Mexico's central bank governor Agustin Carstens speaks during a Monetary Authority of Singapore lecture in Singapore February 5, 2013. REUTERS/Edgar Su