Global Insight Perspective

Significance

The disinflationary trend observed in May and June ended in July, when consumer prices rose 0.39% month-on-month (m/m).

Implications

Inflation is typically modest in the first half of the calendar year before accelerating in the second six months. As such, July's result is not out of line, and speculation will continue as to when Banxico will begin loosening monetary policy.

Outlook

Headline inflation should fall below 4.0% in September and remain there into 2006. In this context, a reduction in the corto (monetary short) is unlikely to be ordered before the final quarter of 2005. Another question on investors' minds is when Banxico will abandon the opaque and ambiguous corto in favour of a benchmark interest rate. Such a switch would likely be well-received as yet another indication that Mexico is running its economy using tools and principles in line with its investment-grade status. 

Inflation Returns with a Vengeance in July

This year looks set to be one of two halves for inflation. Typically in Mexico, the first semester is one of modest price rises, with the second six months seeing sharper increases on the back of seasonal factors such as Christmas and the ending of summer-related electricity subsidies. The inflation report for July, which Banxico released yesterday, suggests that the usual pattern is asserting itself in 2005. The consumer price index fell by 0.10% m/m in June and by 0.25% in May, bringing the accumulated rise for the first half of 2005 to just 0.8%, little more than half the increase registered in the same period in 2004. However, the July consumer price index climbed 0.39%. The main factor causing the pick-up was a 4.46% m/m increase in fruit and vegetable prices, with package holidays and chicken also posting significant rises. Headline 12-month inflation - the measure targeted by Banxico - accelerated to 4.47% from 4.33% in June. 

Given the strongly seasonal nature of Mexican inflation, the result is not disconcerting. Indeed, it is in line with our 0.38% projection. Moreover, the underlying rate - viewed by economists as a far more reliable guide to the trajectory of inflation - stood at 0.22% m/m and 3.44% y/y. The annual rate represents only a modest acceleration from the all-time low of 3.38% recorded in June.

When Will the Corto be Cut?

Given that July's inflation data are not therefore a cause of concern, when will the Bank of Mexico start to unwind the monetary tightening implemented between February 2004 and March 2005? During this period, it raised the corto no less than 12 times. Along with rate increases in the US, this saw the yield on the 28-day Cetes climb to almost 10%. At yesterday's weekly auction, the 28-day Cetes was issued at a yield of 9.61%. Banxico's de-linking of Mexican interest rates from increases in their US counterparts - a decision transmitted in June - makes clear that the tightening phase of the cycle is now at an end, all things being equal. Speculation about when the easing will start is now the norm, with many arguing that this is set to begin in a matter of weeks.

However, Global Insight is more sanguine, believing that Banxico will not act precipitately for the following reasons:

In 2004, Banxico significantly missed its target for annual headline inflation - 3.0% plus or minus one percentage point - with consumer prices rising 5.19% in the 12 months to last December. As such, it will be keen to bolster its credibility with investors.

Although there exists a target range for inflation of 2-4% in effect, the actual goal is 3.0%. The monetary authorities have made clear that they are aiming to bring the headline rate down to this level, rather than merely pushing it below the 4.0% target ceiling.

Inflation expectations have generally been easing in recent months, but have yet to converge with the 3.0% target. The consensus forecast for headline inflation at the end of this year rose to 3.82% from 3.79% last month in Banxico's latest poll of private-sector analysts, with the projections for 2006 and 2007 now standing at 3.88% and 3.76%, respectively. 

Concerns over the outcome of the July 2006 elections, although not currently at the top of investors' agenda, will be at the back of players' minds. Traditionally, presidential elections and the transfer to a new administration (which takes office the December after the elections) have caused investors to fear radical shifts in economic policy. Although market nerves should not be too extreme this time round, tight monetary policy is a tried and tested means of shoring up confidence. 

Wage settlements in July ran at an average of 5.0%, above market expectations of 4.25% and the headline inflation rate. Meanwhile, producer prices rose a significant 0.62% m/m in July, stoked by surging world oil prices. 

Outlook and Implications

Headline inflation should fall below 4.0% in September and remain there into 2006. In this context, a reduction in the corto is unlikely to be ordered before the final quarter of 2005. All the same, the 3.0% actually being targeted by the bank is set to remain elusive in the short term. This may not trouble investors unduly, however, given that the Mexican economy is expanding at a reasonably robust pace and that inflation is already at historical lows, on the core measure, at least.

Another question on investors' minds is when Banxico will abandon the opaque and ambiguous corto in favour of a benchmark interest rate, as employed by leading central banks across the globe. Such a switch would likely be well-received by markets as yet another indication that Mexico is running its economy using tools and principles in line with its investment-grade status.