Yesterday, Banco de México decided in a divided vote to cut the reference rate to 10.75 percent. The decision was very complicated, since there was no consensus in the market, given the most recent complexity in the environment. The tone of the statement was dovishmaintaining the data-dependent monetary stance. The argument behind the cut was the downward trajectory of underlying inflation, as well as the weakening of economic activity.
While it is true that the minutes of the meeting held on June 27th suggested that certain members of the governing board were inclined to cut back, recent inflation trends cast doubt on this bias; and recent market turbulence, translated into a more depreciated exchange rate, made it difficult to estimate the immediate movement with relative certainty.
This week, fears of a recession in the United States produced a new change in expectations regarding the conduct of monetary policy in that country, even pointing out that the Federal Reserve could be carrying out three cuts this year, with a strong probability of seeing one of 50 basis points at the next meeting in September. While it is true that the relative monetary stance has taken a backseat, the cuts by the Federal Reserve give Banxico some room, making the decision easier. Additionally, it has been mentioned that the Fed has been consistently behind the curve, and it would seem that keeping the rate at that restrictive level indicated the same for our central bank, despite the divergence of trajectories that inflation has shown in both countries.
The need to mitigate the high financial cost has also been argued, in anticipation of the reduction that government spending will show next year, suggesting that a reduction in interest rates could contribute to achieving a lower fiscal deficit.
It seems contradictory that Banxico has cut the interest rate while inflation has accelerated for eight consecutive months and is increasingly diverging from the central bank’s target, especially considering that its statement shows a significant deterioration in the behavior of general inflation for the next four quarters.
Evaluating the conduct of the monetary policy and its effects on inflation, there seem to be sufficient arguments for the need to maintain the current level of restriction. To achieve convergence towards its 3 percent target, more significant falls would have to be observed in the underlying component, since we cannot rule out that the shocks in the non-core component will persist for longer and, more importantly, contaminate medium- and long-term inflation expectations. Price formation expectations are made with general inflation, period.
On the other hand, the decline in underlying inflation is attributable to the fall in merchandise prices, which are tradable goods, mostly imported goods. Given a visibly depreciated exchange rate and an uncertain scenario, we cannot rule out that merchandise prices will once again resume their upward trend, albeit at a lag, or that disinflationary progress will be substantially less. The core point of concern is services, and this happens to be the primary target of monetary policy. The shocks in services have possibly been caused by revisions to the minimum wage and increases in wage negotiations, so we can anticipate that they will hardly decline in the short term.
Banxico does not have a dual mandate, and the cost of sacrifice in output would be very limited considering the factors behind the slowdown. Meanwhile, the progress of the most recent underlying component has been very moderate and faces great risk.
Banxico continues to point out that the balance of risks for inflation is biased upwards both domestically and internationally. So what?
