Mexico's subdued inflation set monetary policy dilemma

Mexico inflation remains subdued, and recently, it has surprised the markets on the downside, reducing market expectations for the year-end print. In particular, CPI increased 0.09% 2w/2w in the first half of July as a result of incremental rises in fruit and vegetable prices, partially offset by a reduction in egg prices and a weak core print. Core inflation was 0.10% 2w/2w (consensus: 0.16%), due to higher-than-expected reductions in core other goods prices (-0.19% 2w/2w). After this report, annual inflation decreased to 2.8%, from 2.9% in the last fortnight of June, consolidating a downward trend. This report is in line with the year-end forecast of 2.6% as base effects are expected to dominate in the second half of the year. Consensus year-end inflation is at 2.9%, according to the latest Banamex survey, and the market will gradually incorporate the lower-than-expected print. Also, annual core inflation decreased to 2.30% from 2.35% previously. 

Another highlight of the report is that FX pass-through has had a very limited effect in the recent inflation dynamics. In particular, in the last inflation print, durable goods prices declined 0.23% 2w/2w, while during the same fortnight of 2014 they decreased 0.13%. This would suggest there is still some weakness in the demand for these goods and room to accommodate additional pass-through, particularly after the recent weakness of the peso and the fact that the MXN will continue depreciating against the USD as a US Fed hike approaches. 

Nevertheless, since inflation will likely remain below target during H2, Banxico will face a dilemma when the Fed decides to increase rates. For instance, the MXN has depreciated faster than market expectations and inflation should start accelerating at some point; however, the economy is still far from booming. 

"We think the board might keep a neutral tone in the July 30 policy meeting, highlighting the risks to inflation but acknowledging that the domestic conditions should keep inflation under control," says Barclays.