Mexico’s peso closed at its strongest level against the dollar in five years Friday after the Bank of Mexico raised its benchmark interest rate, citing higher inflation. The currency was quoted in Mexico City closing at 10.275 pesos to the dollar, compared with 10.3185 at the open and Thursday’s close of 10.3120. The Bank of Mexico raised the overnight rate to 7.75 percent, from 7.5 percent, in its first monetary policy move since last October.

(Dow Jones, 21-June-2008 )

This was a surprise to the U.S. forecasters, but was a possible scenario, according to the “Latin American Regional Report” Mexico and Nafta June 2008 newsletter (subscription only – around 1200 POUNDS a year… something the Mex Files doesn’t have access to very often… but then the Mex Files only asks … nicely… for 36 DOLLARS a year):

The Banco de México noted at the beginning of June that inflationary expectations are rising. The consensus forecast for annual inflation in 2008 is now 4.39%, the highest projection in 28 months. More worryingly for policymakers, inflation is now running above the level of wage increases.

The danger is that inflationary expectations, which the central bank compiles from around 30 independent economic forecasters, will come in above 5% in May or June. Such a rise may prompt trade unions to demand higher wages.

The big question for the Banco de México is whether it will follow the lead of central banks in South America, which have raised interest rates to head off inflation, or whether it will follow the US Federal Reserve Board, which has ignored the rise in inflation in US. The US Fed has been clear that its policy priority is to avoid a domestic economic slump. Only when it is sure that the US economy has avoided a slump will it turn to dealing with inflation.

For the government the issue is slightly different. It will only face problems if the central bank fails to act and trade unions start to demand big wage increases in 2009. For the past eight years, Mexican employers have been able to increase wages in real terms. Figures from the Secretaría del Trabajo show that from 2000 to 2007 wages rose by 42.4% but inflation over the period was 34.5%. Wages in 2008, however, are likely to fall in real terms, for the first time since 1996.

The fall in real wages is unlikely to be as dramatic as it was in 1980s or in the last great economic crisis in Mexico in 1995. This year the decline is likely to be 0.5% -1%.  Nonetheless, a decline in purchasing power, coupled with the government’s problems in fighting the drug trade, will complicate the government’s prospects in next year’s mid-term congressional elections. The government’s big card, however, is its strong fiscal position. Unusually this is not a result of the surge in oil prices but of a highly successful fiscal reform.

The Banco de México has already increased its 2008 inflation forecast by 0.5 of a percentage point. It now does not expect inflation to fall below 4.25% at any point this year. For the next two quarters the central bank expects annual inflation to range between 4.5%- 5%. Only in the final quarter of 2008 will there be an improvement, when the range falls to 4.25%-4.75%. In the 12 months to 15 April, the annual inflation rate was 4.53%.

The central bank governor, Guillermo Ortiz, said that higher international food prices were largely to blame, while higher steel and cement prices were also contributing.

The Banco de México only expects inflation to start to fall significantly in 2009. It forecasts a rate of 3.75%-4.25% in the first quarter of 2009 and then 3.5%-4% in the second quarter, before the rate settles, conveniently back on target, at between 3% -3.5% in the second half of 2009.

What the central bank inflation forecasts imply is that there will be little monetary policy stimulus (in the form of interest rate cuts) for the foreseeable future. On the other hand the government’s strong and improving fiscal position suggests that the government may ratchet up spending, especially if there are clearer signs of any economic slowdown in the US having an effect on Mexico.

In following the South American central banks’ leads, the Mexican administration is echoing Lopez Obrador’s program in the last election. That called for loosening ties with the U.S. economy and creating closer ones with the South American countries, especially Mercosur.

A second point, also raised by Lopez Obrador, was that Mexico should concentrate on growing the domestic market rather than depending on exports. This too seems to be what Banco de Mexico is trying to do. Certainly the downturn in the U.S. economy is going to have a huge effect here, but by staving off the worst of it, even if it means slower growth, should minimize those effects.

From elsewhere in the same newsletter, there is this:

President Felipe Calderón Hinojosa sells himself to the US and the Mexican business community as a staunch free marketer and the complete opposite of Andrés Manuel López Obrador, the leftwing populist Calderón defeated in the 2006 elections. Calderón’s taste for subsidies, however, belies his reputation.

Calderón first revealed this tendency in 2007 when he fixed the price of tortillas and then retreated from a plan to increase fuel taxes. These policies have expanded since then. Fuel subsidies on petrol and diesel will now cost the government M$200bn (US$19.2bn) this year. Food subsidies (designed to check inflation) will add another M$4.5bn to government spending in 2008.

“Latin American Regional Report” sees this as a political move, but the promise not to raise lower the gasoline subsidy, which would mean higher gasoline prices, may also be an attempt to hold down inflation, even if it retards economic growth.

The problem is that the subsidies are economically inefficient and unsustainable. They benefit the big users, who are almost by definition, the rich. Essentially, Calderón is using the proceeds from a non-renewable asset, oil exports, which in theory belongs to all Mexicans, to subsidise the rich. Oil export revenues are booming, providing the government with the fiscal resources to buy off protests.

The subsidy sums are enormous by Mexican standards. The M$200bn fuel subsidy is greater than the annual federal education budget and four times what the welfare ministry, Sedesol, was budgeted to spend this year. As one leading political commentator, Sergio Sarmiento, puts it, to spend all this money, which could be invested productively, is absurd and unsustainable.

I tend to agree with the conservative Sarmiento. Mexico is going to need more – and better paying – jobs over the next several years, especially as the percentage of university graduates (which have trouble finding work now) increases. Still, slow growth is better than no growth, but we all could use a cost of living raise down here.