Commentary: MXN's Medium Term Future Tied to Banco De México Policy Statement

This Friday, Banco de México issues its first monetary policy decision after cutting its key policy for the first time since 2009.  For nearly all of 2012, and especially through the height of the Eurozone crisis last June, the central bank kept a firmly hawkish bias with two related themes.  The slightly above target inflation observed in the general index was due to 'transitory shocks' in commodity prices, which tended to push up food and energy costs.  Core inflation continued to be on target, registering around three percent.  Despite stable core inflation, the bank communicated its committent to achieving its inflation target in nearly all its policy announcements last year.  Paraphrasing from the Spanish, "Despite the transitory nature of the shocks causing elevated inflation, rate increases may be necessary to anchor inflation expectations and prevent the contamination of the mechanism of price transmission in the broader economy."  In sum, the bank was not about to let external factors derail its policy objective of low and stable inflation, even if acting meant slower growth.  

By 2013, inflation had slowed in both the core and non-core indices.  Growth had also slightly moderated.  Therefore, the central bank shifted its bias.  Inflation had been tamed, so now "a rate reduction may be advisable to help the economy adjust to slower growth and constrained inflation."  In March of this year, Banco de México acted by cutting the overnight interbank lending rate by fifty basis points to all time low of 4 percent.   
  
Since then, the Mexican peso has continued to appreciate, mainly because of Mexico's excellent fundamentals and a promise by the bank that the cut was a one-off and not the beginning of an "easing cycle." Today, inflation stands at 4.25 percent, or 1.25 percentage points off the central bank's three percent objective.  More troubling, core inflation stands at 3.02 percent, while non-core inflation is a whopping 8.25 percent.  In other words, the transitory shocks, which seemed to have abated earlier this year, have returned.  The board must now decide whether stable and low core inflation is good enough, and reaffirm its intentions to cut rates should growth slow, or if it must meet its inflation target at all costs, even it means sacrificing growth, and fighting external shocks.  Meanwhile, all time high net longs for the Mexican peso and record foreign bond buying demonstrate the incredibly bullish investor sentiment towards the Latin American giant.  Signalling the possibility of more easing may cost the central bank credibility, since only six weeks ago in promised it would not cut further.  On the other hand, a reassertion of a hawkish tone may well send  USD/MXN into sub ten territory given the market's current euphoria.  In general, Banco de México has been very open to peso appreciation, but policy makers never like to see currencies rise too far too fast.  Therefore, the formulation of the exact wording of the policy statement will be a careful dance for the central bank.  The future Mexico's currency hangs in the balance.