Mexico interest rate surprise

The rate hike is surprising. The statement is to reinforce the bank's credibility.

The motivation is pretty obvious that the bank wants to reverse the inflation expectation. Currently the expectation is at the upper bound of the target. Here is a few questions we need to look at.

1. Inflation expectation is formed through many different channels. Most cases, it is formed from the inflation history. Of course, there are two ways to have inflation. Supply shock or demand shock.

A. Demand shock is the loosing monetary policy. Mostly due to fiscal pressure on the central bank financing. This was typical in EM in the past, and some EM today. In this case, the bank has an important role to convince the public that printing money to finance the fiscal deficit is not an option. That is one reason we have the inflation targeting institute or an independent central bank. Also under this case, inflation is driven by the government. As governemnt does not change every month, inflation expectation is formed as a response and tends to be sticky.

B. Supply shock on the other hand is not a direct result of policy failure. It is the weather or some global factor that the government/central bank has limited tools to counteract. In this case, inflation expectation tends to be short term and less sticky. In some sense it is more likely to be adaptive, adapted to a few month in the past. Market observes inflation yesterday tends to think it will be similar today because the transition probability for weather switch from one day to another is low. In other words, if the inflation figure drops today more than expected (due to demand slow down for example), expectation tends to adapt and adjust downward fairly quickly. Also because of that, the effect of central bank hike is smaller as the source is inflation is not from government. This seems what is expected in Mexico.

2. Anyhow, rate hike is real today. what will be next? I think the rate cycle (if there is) should be done. Inflation expectation should go down partly because of this rate hike, but more importantly, the diminishing of the supply shock. Of course, if there is another unexpected supply shock, the story will be different, but that is not the baseline.

3. The real concern is if the real economy response to the interest hike. The economy is cooling down. The uncertainty between the weak US growth and Mexico economy is high. If Mexico faces external sector slow down, and if domestic economy response negative to the rate hike, the effect will not be pleasant. This paves the way for interest rate adjustment.