Banxico Quarterly Report with a Dovish Tone

This week, the Bank of Mexico published the Q2 2019 inflation report, with an analysis that describes the evolution of the global and national economies and of financial markets. In general, the perceived tone reflects a greater concern for the country’s economic stagnation, resulting from both internal and external factors. Externally, the global economic slowdown resulting from the ongoing U.S.-China trade war has harmed the economy both nationally and globally. For example, the German economy registered negative growth in the second quarter of the year owing to the drop in manufacturing exports to China. In fact, the implementation of tariffs for China and the US is increasing the prices of end products in both countries, producing an evident slowdown, particularly for the Asian country. For its part, the US has already reported a 2.1% annualized quarterly growth (seasonally adjusted) in the second quarter of the year, a 3% decrease compared with the first quarter. Moreover, the US Purchasing Managers Index contracted to levels below 50 points.

Internally, the report highlights the growing uncertainty resulting from some economic policy actions and greater-than-expected government underspending. The report repeatedly mentions that the gap between the real and potential GDP has widened. Industry is still in recession, particularly owing to the persistent decline in the mining sector, while construction growth rates are also negative and the slowdown in private consumption is evident. In addition, there are already signs of a slowdown in the country’s labor market. The trend in unemployment is beginning to reverse, with thousands of formal jobs having been lost during the first seven months of the year.

The governing board explains that inflation has followed a clear downward trend, although core inflation persistently remains at around 3.8%. However, there has been good news from the non-core component prices, in particular the sharp slowdown in energy prices. Given the figures in the report, the board expects inflation to converge towards the center of the target (3%) in Q2 2020. Nevertheless, core inflation is now expected to surpass the previous quarter’s forecast.

Most of the governing board members felt that it was the right time to cut the interest rate by 25 basis points. Only one member, Javier Guzmán Calafell, disagreed, arguing that adopting an accommodative monetary policy position would be premature without knowing the economic package proposed for 2020 (to be delivered in September to the Congress of the Union) or the rating agencies’ stance regarding sovereign risk and Pemex. Any adverse news in either case would result in a devaluation and be detrimental to the country’s inflation expectations. The evolution of public finances in an environment of falling VAT collection, owing to the less dynamic private consumption, must be observed.

The common denominator of the report is that the board is sending a clear signal that more cuts can be expected in the future. Interestingly, that the interest rate cut appears to have been a response to that of the United States Federal Reserve. The board seems to believe that it should maintain the current US-Mexico rate differential.

What are the expectations for the future? The report announced a new cut in growth expectations for the year, between 0.2 and 0.7%. I think key decisions need to be made to reactivate investment. To start with, the agreement reached between the federal government and private and foreign enterprise on the issue of CFE gas pipelines is promising, since this will help to improve private investment attraction. However, it would be much better for the government to reactivate in full the energy reform implemented by the last administration, above all in relation to oil auctions and investment in deep-water crude oil exploration.

Worryingly, the economic perspectives of the United States reveal a greater probability of a recession for this country, which could have a negative impact on Mexican manufacturing exports, the country’s only dynamic sector. The economic package for 2020 will be of utmost importance. The federal government needs to bulletproof public finances and have a plan for any possible deterioration in the external environment. For now, we can expect at least one more interest rate cut in the near future.