The Banxico-Fed Decoupling

One could assume that the Mexican central bank might aspire to keep its rate differential relatively wide, amid the economic uncertainty and the visible exchange rate depreciation triggered by domestic and external factors. Nonetheless, some members of Banxico’s governing board have argued that financial markets have remained relatively ordered, and, furthermore, the cyclical position of the Mexican economy and a less adverse inflation outlook justify a shorter rate differential.

Uncertainty has been on the rise in Mexico since last June. Firstly, a series of political constitutional changes, especially those aiming to reform the judiciary branch of government, raised some doubts regarding the rule of law and the business climate in Mexico. Furthermore, the return of Donald Trump to the White House, and, moreover, his tough stance on trade, virtually killed most of the optimism regarding the potential benefits Mexico could reap from the nearshoring phenomena.

Naturally, domestic financial markets took the hit under this complex scenario. Between May and February, the Mexican peso depreciated almost 20% against the US dollar. It is intriguing to understand why the Bank of Mexico (Banxico) decided not only to continue its interest rate cutting cycle, but to increase the pace, at times when domestic markets are showing high volatility, and, furthermore, after the Federal Reserve (Fed) hit the brakes on its own monetary policy normalization process. Hence, the Banxico-Fed rate spread closed from 550 to 500 basis points (bp), worrying many market observers that this could lead to increased financial volatility, or, at least, a higher exchange rate.

On the other hand, some members of Banxico’s governing board have said that the monetary policy stance relative to the Fed is just one of many pieces of data they take into consideration on each of their monetary policy decisions, while highlighting that the current interest rate spread stands somewhat above its historical average, which stands around 475 bp. They also pointed out that, despite the volatility,  financial markets activity has remained relatively ordered. A couple of members added that the foreign exchange rate pass-through effect on inflation is currently relatively small.

Arguing in favor of a decoupling from the Fed, some officials referred to the divergent cyclical conditions between the Mexican and the US economies. Particularly, economic activity in Mexico has demonstrated increased weakness recently, as shown by last year’s GDP growth of 1.3%, while, on the other hand, the US economy expanded at a solid 2.8%. Hence, while a robust US economy has prevented the Fed from reigning in inflation in recent months, subdued activity in Mexico may give Banxico some room to reduce monetary restrictions.

In fact, some officials judged that the inflation outlook in Mexico has improved, not only due to a weak economy, but also as external shocks, namely the effects of the pandemic and the war in Ukraine, have virtually faded away.

Although many of these arguments are solid, and progress has been made in reducing inflation to more “normal” levels in the last couple of years, I am still not convinced that the inflation outlook has improved substantially. Especially in face of a depreciated and volatile foreign exchange, and significant wage pressures not accompanied by any improvement in labor productivity. In fact, it may be that not everyone at the central bank is convinced of such improvement. Otherwise, how can we explain that in November’s monetary policy communiqué, Banxico projected that inflation will converge to the 3% goal by 4Q25, while last February’s forecasts suggested that said convergence would not materialize until 2Q26? Additionally, Banxico has constantly reminded us that risks on its projections remain skewed to the upside.

No doubt Banxico still has some room to ease monetary policy, though a more careful approach and procuring an attractive interest rate spread makes sense to me until uncertainty and financial market volatility recede, and the inflation outlook shows additional improvement. Relaxing monetary policy too fast may hinder all the progress made on the inflation front and compromise the central bank’s credibility.