Banco de Mexico’s April Surprise
May 01, 2007
By Gray Newman | New York
It’s been a tough year for Mexico’s central bank so far. No sooner had 2007 begun than Banco de Mexico’s board began to realize that its fairly benign view of inflation was running up against yet another supply shock, this time involving corn and tortilla prices. And Banco de Mexico wasn’t the only one wrestling with how to respond to rising prices: the new administration was also caught off guard and worried that soaring tortilla prices could turn into a rallying cry for the opposition.
Banco de Mexico had a dilemma in January. Right up until the end of the year, the central bank had projected headline inflation to fall below 4% by the end of 2006 on its way to near 3.5% at the end of 2007. The unexpected tortilla and sugar price hikes meant that inflation would start the year from a higher level and delay the return of inflation to below 4%. More worrisome still, the higher level of prices combined with a difficult period of comparison (early 2006 inflation was unusually low thanks in part to a drop in produce prices) meant that the modest surge in year-over-year headline inflation during the first months of 2007 would look much worse. Instead of having inflation in 2007 on a path from below 4% to 3.5%, the year was shaping up to produce headline inflation rising to 4.5% by June or July before trending downward.Banco de Mexico’s dilemma was two-fold. First, a hike in January would have come with no advance warning or preparation for the market. Indeed, up until the new year, the market had been working with a benign inflation path much as set out by Banco de Mexico on November 24 and reaffirmed in its communiqué on December 8. Second, a move by the central bank might have actually contributed to additional political noise and price pressures. If the central bank was willing to hike, then wage setters might have argued that it was evidence that inflation was on the rise and hence union calls for ‘emergency’ wage increases were warranted. Instead, Banco de Mexico decided to take a first step by closing the door to any possibility of a reduction in rates. It also decided to use new, more forceful language that it was ready to take the necessary action if the supply shocks seen in January began to have a negative effect on a trio of variables: a broader group of prices (beyond sugar and tortillas), medium-term inflation expectations and wages. February’s ultimatum By February, Banco de Mexico began to realize that the surge at the beginning of the year was likely to keep headline inflation higher for longer. Headline inflation would like remain above 4% and at times closer to 4.5% beyond the first half of the year and into the third quarter. Meanwhile, the specter of higher corn and other grain prices spiralling into a broader surge of food prices and inflation was getting locals nervous. A number of analysts began to call for Banco de Mexico to hike interest rates to reassert its commitment to its 3% target. And within the central bank there was new concern over the central bank’s credibility. The argument went as follows: the longer that inflation remained this far from the target — it was now moving well above the upper band of 4% — the greater the risk that it would begin to contaminate expectations or wages. The central bank shouldn’t wait until such contamination takes place; indeed, it could prove much more costly to do so. The fact that wages or expectations hadn’t moved was a sign of credibility that had been gained from past actions and which the central bank should jealously guard (see “Mexico: Banco de Mexico’s Ultimatum”, Global Economic Forum, March 6, 2007). The problem, however, was in communicating this new willingness to act in a pre-emptive stance. The board produced an unfortunate communiqué, which seemed to reduce monetary policy to a rigid rule that narrowly focused on whether there was an improvement in March core year-over-year and monthly inflation. The February 23 communiqué threw down the wrong gauntlet by arguing that the central bank would act if March’s core numbers did not show an improvement. All but missed by most in the market was the central bank’s other statement in the communiqué that while its carefully monitored trio (other prices, expectations and wages) had not been contaminated, the fact that inflation would remain “elevated for various months” increased the “risk” of just such a contamination. What the central bank was trying to convey was that it would not necessarily wait until one of the trio were contaminated to act with a hike in interest rates (see “Mexico: No Hike, Comfort”, Global Economic Forum, March 20, 2007). Unfortunately, while the central bank was trying to avoid rigid rule limiting when it could hike rates, it set itself up with a much more rigid precept that if read literally was even more constraining. March’s balance
Finally, in March Banco de Mexico communicated clearly that it had come up with a new set of guidelines for monetary policy. It would no longer feel compelled to wait until other prices began to move, nor would it have to wait for medium-term expectations to deteriorate, nor would it have to wait for an uptick on wages. The trio had been deposed. Instead, the central bank would act if the “balance of risks” deteriorated even if inflation remained on track. The problem with the statement, however, was two-fold. First, the “balance” was never clearly defined in the communiqué. Second and more importantly, the central bank decided not to act even though by this time it was projecting headline inflation to fluctuate well above the 4% upper limit into the third quarter. By unveiling the new “balance of risk” focus but at the same time declining to hike interest rates, Mexico watchers concluded no imminent hike was in the works. After all, if the central bank was able to apply the “balance of risk” guidelines and decide not to hike in March, it was unclear what would trigger the central bank to move unless there was a significant upswing in inflation or in expectations or wages. April’s surprise
Then came the April 27 surprise move to hike interest rates just one day after posting a deflationary first half of April report (-0.21%) and on the same day that the US announced that first quarter GDP was the weakest in four years. Of course, the first half of April deflation reading was largely the result of a few states moving forward a program of lower summer electricity prices and an early drop in packaged tourism prices. But still, core (ex-electricity) was tamed and core services (ex-tourism) was showing a slowing. What then caused Banco de Mexico to act? What constituted the “additional deterioration to the balance of risks” that the central bank had warned in March could trigger action? Two events appeared to have triggered Banco de Mexico’s April move: falling market interest rates and the spillover of higher grain prices into consumer food products. Even as headline prices were moving higher and the path of core prices was uncertain, the market was pushing interest rates lower across the curve. While the central bank expected inflation to fall by the end of the year, there were risks to that forecast: risks that were hard to see in the direction of interest rates. Indeed, on the eve of the April decision some market participants argued that if Banco de Mexico even so much as cited signs that the economy was softening, such a statement could spark another rally. The market, from the vantage point of the central bank, was ready to party: a risky attitude should the inflation environment once again turn out to surprise the central bank with more negative news this time from processed foods where grains are used as inputs. What’s next?
There is a tension in the April statement between the characterization of the hike as “preventive” and the language on responding to any “deterioration in the balance of risks”. The preventive language suggests that the 25bp hike to 7.25% may be all that is needed, a sort of vaccination or booster. But we fear that the central bank will be forced to act again —either in May or June — as grain prices remain under pressure. Accordingly, we are revising our forecast to incorporate at least one additional move, bringing interest rates to 7.5% (up from our previous forecast of 7.0% by year-end). It’s true that the Mexican economy is slowing. But Banco de Mexico is unlikely to be convinced that, faced with a supply shock, a moderation in growth will necessary be enough to keep inflation on the path towards 3%. Indeed, the risk to our forecast is that Banco de Mexico hikes in both May and June. We still forecast inflation to reach 3.6% by year-end, although our ‘current conditions’ model suggests that that may be ambitious and highlights additional risks in 2008. Bottom line
We suspect that the current inflation uptick will fade. After all, most of the upturn is in the year-over-year inflation series in which the base of comparison is difficult in the coming months. Extrapolate current monthly trends to the year’s end and the year-over-year reports should begin to improve. Nonetheless, we expect Banco de Mexico to act again in order to signal to economic agents that it will work to ensure that the current grains-to-food adjustment in relative prices does not spawn a new round of unrelated price hikes. We had wrongly argued that this would be the year of ‘no hikes, but no comfort’. What Banco de Mexico discovered was that without a hike, no amount of warnings in the monthly communiqués was enough to leave Mexico watchers in a ‘no comfort zone’. We suspect that it will be forced to move again.
Important Disclosure Information at the end of this Forum
Current Account Surplus Amid Weak Domestic Demand
May 01, 2007
By Chetan Ahya | Mumbai
Current account rose to US$2.3 billion in March: The current account came in at US$2.3 billion (versus +US$1.7 billion in February). The net services and transfers balance fell to US$0.1 billion (versus US$0.5 billion in February). The narrowing in net services and transfers is in line with the seasonal trend. The trade balance, which came in at US$2.2 billion, was bolstered by high export growth of 19.0% YoY (versus 18.4% YoY in February), while weak domestic demand crimped imports (+0.5% YoY versus +6.3% YoY in February) even though the stronger baht improved purchasing power. Disconnect in trade data in US$ terms and Bht terms persisted: The disconnect between trade data in US$ terms and baht terms continued, highlighting that the strong currency might be weakening exporters’ revenue in baht. Exports rose 7.1% YoY (custom basis, Bht terms), versus +7.9% YoY in February). In terms of the product breakdown, machinery (+8.7% YoY & 4.0%-pt) and manufactured goods (+19.7% YoY & 2.5%-pt) were the stronger segments.
Imports weakened on the back of consumer and capital goods: On a custom basis (Bht terms), imports declined 8.7% YoY in March (versus a 5.6% YoY fall in February). Consumer goods imports did not do well (-5.7% YoY versus +3.5% YoY in February). Consumers are slowing down on spending of both durable (-5.0% YoY versus 0.7% YoY in February) and non-durable goods (-6.3% YoY versus 5.7% YoY in February). Investment decisions continued to be delayed — capital goods imports (-14.8% YoY versus -15.6% YoY in February) remained in negative double-digit territory. However, raw materials and intermediate goods sustained at a momentum of 3.1% YoY (versus +6.7% YoY).
Important Disclosure Information at the end of this Forum
Disclosure Statement
The information and opinions in this report were prepared or are disseminated by Morgan Stanley & Co. Incorporated and/or Morgan Stanley & Co. International plc and/or Morgan Stanley Japan Securities Co., Ltd. and/or Morgan Stanley Dean Witter Asia Limited and/or Morgan Stanley Dean Witter Asia (Singapore) Pte. (Registration number 199206298Z) and/or Morgan Stanley Asia (Singapore) Securities Pte Ltd (Registration number 200008434H) and/or Morgan Stanley Taiwan Limited and/or Morgan Stanley & Co International plc, Seoul Branch, and/or Morgan Stanley Dean Witter Australia Limited (A.B.N. 67 003 734 576, holder of Australian financial services licence No. 233742, which accepts responsibility for its contents), and/or JM Morgan Stanley Securities Private Limited and their affiliates (collectively, "Morgan Stanley").
Global Research
Conflict Management Policy
This research observes our conflict management policy, available at www.morganstanley.com/institutional/research/management_policies.html
Important Disclosures
This report does not provide individually tailored investment advice. It has been prepared without regard to the circumstances and objectives of those who receive it. Morgan Stanley recommends that investors independently evaluate particular investments and strategies, and encourages them to seek a financial adviser's advice. The appropriateness of an investment or strategy will depend on an investor's circumstances and objectives. This report is not an offer to buy or sell any security or to participate in any trading strategy. The value of and income from your investments may vary because of changes in interest rates or foreign exchange rates, securities prices or market indexes, operational or financial conditions of companies or other factors. Past performance is not necessarily a guide to future performance. Estimates of future performance are based on assumptions that may not be realized.
With the exception of information regarding Morgan Stanley, reports prepared by Morgan Stanley research personnel are based on public information. Morgan Stanley makes every effort to use reliable, comprehensive information, but we do not represent that it is accurate or complete. We have no obligation to tell you when opinions or information in this report change apart from when we intend to discontinue research coverage of a company. Facts and views in this report have not been reviewed by, and may not reflect information known to, professionals in other Morgan Stanley business areas, including investment banking personnel.
To our readers in Taiwan: This publication is distributed by Morgan Stanley & Co. International plc, Taipei Branch; it may not be distributed to or quoted or used by the public media without the express written consent of Morgan Stanley. To our readers in Hong Kong: Information is distributed in Hong Kong by and on behalf of, and is attributable to, Morgan Stanley Dean Witter Asia Limited as part of its regulated activities in Hong Kong; if you have any queries concerning it, contact our Hong Kong sales representatives.
This publication is disseminated in Japan by Morgan Stanley Japan Securities Co., Ltd.; in Canada by Morgan Stanley Canada Limited, which has approved of, and has agreed to take responsibility for, the contents of this publication in Canada; in Germany by Morgan Stanley Bank AG, Frankfurt am Main, regulated by Bundesanstalt fuer Finanzdienstleistungsaufsicht (BaFin); in Spain by Morgan Stanley, S.V., S.A., a Morgan Stanley group company, which is supervised by the Spanish Securities Markets Commission (CNMV) and states that this document has been written and distributed in accordance with the rules of conduct applicable to financial research as established under Spanish regulations; in the United States by Morgan Stanley & Co. Incorporated, which accepts responsibility for its contents. Morgan Stanley & Co. International plc, authorized and regulated by Financial Services Authority, disseminates in the UK research that it has prepared, and approves solely for the purposes of section 21 of the Financial Services and Markets Act 2000, research which has been prepared by any of its affiliates. Private U.K. investors should obtain the advice of their Morgan Stanley & Co. International plc representative about the investments concerned. In Australia, this report, and any access to it, is intended only for "wholesale clients" within the meaning of the Australian Corporations Act.
Trademarks and service marks herein are their owners' property. Third-party data providers make no warranties or representations of the accuracy, completeness, or timeliness of their data and shall not have liability for any damages relating to such data. The Global Industry Classification Standard (GICS) was developed by and is the exclusive property of MSCI and S&P. Morgan Stanley bases projections, opinions, forecasts and trading strategies regarding the MSCI Country Index Series solely on public information. MSCI has not reviewed, approved or endorsed these projections, opinions, forecasts and trading strategies. Morgan Stanley has no influence on or control over MSCI's index compilation decisions. This report or portions of it may not be reprinted, sold or redistributed without the written consent of Morgan Stanley. Morgan Stanley research is disseminated and available primarily electronically, and, in some cases, in printed form. Additional information on recommended securities is available on request.
|
