Mexico odd-man out in region with inflation outlook dimming

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Monday, October 17, 2016

Bucking a regional trend that suggests disinflationary forces are beginning to slow growth in consumer prices, Mexico's recent peso depreciation and other factors could be leading the nation in the opposite direction.

"Disinflationary forces will be in evidence in South America, but we believe Mexico, which saw inflation fall when others experienced increases, may face rising price pressures in coming months," said Swiss bank UBS in a regional report on the evolution of inflation in Latin America. "Higher fuel prices, the risk of an FX pass-through, and more generalized price pressures will likely lead Banxico to further tightening."

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Mexico's central bank has raised the benchmark rate a total of 175 basis points since December, most recently in September, hiking it 50bp to 4.75%. The increases have been out of step with the US Federal Reserve's continued pause on hikes, with Mexico's monetary policy driven by low oil prices, the weakening peso and the Brexit event. Most analysts see a further hike by year-end, which would add further pressure to consumer prices.

In contrast, the UBS analysis shows South America going the other way, now recovering from the worst El Niño weather effects since 1997, as food prices are starting to fall. Furthermore, UBS research also shows that improving FX rates and high unemployment will slow inflation in many countries and that nations adopting spending cuts to adjust to the post-commodity boom could also work against inflation.

Mexico's general inflation has remained within the central bank target range of 1-3% year-on-year since May 2015. However, after rising a fourth month in a row, inflation reached 2.97% in September, significantly higher than the 2.73% seen in August.

The average estimate for inflation at end-2016 was 3.20% in the central bank's September private sector survey, up from 3.12% in the August survey.

Citibanamex poll of analysts, released October 5, showed that a mean of 22 banks see 2017 inflation at 3.40%, up from the 3.32% in the previous bimonthly survey.

Scotiabank gave the highest estimate, seeing annual inflation reach 3.70-3.86% in 2017.

Mario Correa, Scotiabank Mexico's chief economist, speaking with newspaper El Universal, cited the peso as the chief reason for the higher rate.

"The poor September inflation results suggest there could be an even more notable increase in prices," he told the daily.

"Headline CPI is now at [the high end of] the central bank's target [of 1-3%] and leaves it on track to move above the target over the coming months," read a recent report from Capital Economics.

Looking at the potential for FX pass-through in Mexico, UBS noted the currency has weakened more than 10% since April 2016.

"Although we see MXN weakness as largely reflecting a slippage in fundamentals (e.g. widening current account deficit; falling portfolio inflows; and deteriorating fiscal position), we believe part of the move can also be explained by the risk that the US presidential elections could result in a greater degree of trade protectionism vis à vis Mexico."

The scenario of higher protectionism is associated with the possibility of Donald Trump taking the presidency. This has raised alarms from Mexican officials, including central bank governor Agustín Carstens, though the impact on the peso may be very short term.

While the contest seems certain to bring strain on the peso through election day on November 8, polls are now heavily favoring Hillary Clinton, and a win by the democrat could bring immediate relief to the peso.

The final presidential debate to be held October 19 will be the last major forum for the candidates to address the nation before the election.

UBS noted that while FX pass-through to inflation appears likely in Mexico, the nation is less exposed, adding that a 10% depreciation would lead to 100bp of inflation within a year in Chile or Peru, whereas it would only produce about a 50bp increase in Colombia, Brazil and Mexico.

UBS added, "The critical question surrounding Mexico is why the FX pass-through has been so low thus far. In our view, FX pass-through is already visible - judging from the increase in merchandise good prices and the widening of inflation pressures as measured by diffusion indices - but headline inflation has been held in check by a handful of items and rubrics (primarily mobile phones, rents, fuels and fresh food prices)."

Mexico has insisted it will not increase taxes in its 2017 budget, with the revenue portion of the budget to be decided this month. However, it intends on cutting 239.7bn pesos (US$12.7bn) to bring about the first primary budget surplus in years. That said, achieving this might be difficult with the 2018 presidential election cycle starting up in Mexico, among other issues like fuel prices.

"The liberalization of gasoline prices could be an important inflationary pressure," added UBS.

The bank said it agrees with the central bank's assertion that the balance of risks for inflation has deteriorated - underscored in the minutes of the latest policy meeting. UBS calls for inflation to hit 3.2% in 2016 and 2017, "though the risks to the latter seem skewed to the upside."