Banxico can cut rates as soon as it's comfortable, and we think there's plenty of room. We identify a clear path to sub-7% through 2024/25, with the only constraint being a lack of willingness to kick things off. Once this gets going – even though there's a lot priced in – we identify room for a 180bp convergence to the US in the 2yr and 80bp in the 10yr. It could be more.
How much room does Banxico have to manoeuvre the policy rate lower? Lots
Let’s start with a simple question – how much room does Mexico's central bank (Banxico) have for policy rate cuts? We answer this question in two phases. First, we assess what room Banxico has based purely off where we are now. So, no forecasting; simply a purely technical and steady state analysis.
We use three ingredients to help identify room for a policy rate manoeuvre:
- The classic nominal official rate differential versus the Federal Reserve is always important. It’s the spread that the markets focus on, and it’s the one that directs FX forwards.
- The internal real rate is the domestic policy rate less inflation – the real policy rate. It’s the one that affects domestic circumstances.
- The external real rate differential is the domestic real policy rate versus the real Fed funds rate. It’s the link to the currency, control of it, and feedback to domestic inflation.
- The classic rate differential is 5.9%, versus a 4.8% average. The delta is 1.1%.
- The internal rate is 6.6%, versus a 1.2% average. The delta is 5.4%.
- The external real rate differential is 4.7%, versus a 2.7% average. The delta is 2.0%.
Applying an equal weighting gives us 2.7%. So, Banxico can cut its official rate to 8.5% from the current 11.25%. Remember, this is a steady state analysis based off where we’ve been and where we are now, and no more.
One issue here is the policy rate differential vs the US would now be 1.7pp (percentage points) below average, and the real external rate is 0.8pp below average. It’s a stretch, but doable for two reasons. First, the absolute policy rate differential is still 3.1% and the absolute real external rate is 1.9%. It’s just the deltas versus average that are negative. Second, they are being cushioned by the real internal rate being at 2.6pp above average.
As can be seen in the graph below – with Banxico at 8.5% and no other changes – the rates gap is now zero, and thus any further cuts would be an overshoot to the downside.
Click here to find out how much room we believe Banixco has for rates to go lower.