UPDATE 3-Mexico cuts key rate as economy stumbles, peso exposed

Fri Sep 6, 2013 3:45pm EDT

* Banco de Mexico cuts benchmark credit costs to 3.75 pct
    * Move defied analysts' expectations for unchanged rates
    * Policymakers set weak growth against inflation, peso


    By Michael O'Boyle and Alexandra Alper
    MEXICO CITY, Sept 6 (Reuters) - Mexico's central bank
unexpectedly lowered borrowing costs on Friday to counter a
slump in growth, keeping the door open to a further cut and
leaving the weak peso vulnerable if the United States starts to
unwind stimulus.
    The Banco de Mexico cut its benchmark rate by
25 basis points to 3.75 percent, the lowest level since the key
rate was introduced in early 2008, in a move that was predicted
by few economists.
    But investors welcomed the move to shore up Latin America's
No. 2 economy. While the peso at first wilted on the cut, it
bounced back higher while bonds and stocks rallied.  
    Economists had doubted Mexico would move ahead of the U.S.
Federal Reserve, which could begin winding down its $85
billion-a-month bond buying program as early as this month. Such
a move could spark volatility in global financial markets.
    But policymakers said inflation would keep cooling in the
coming months while risks to growth had deepened significantly
compared to the central bank's previous forecasts. 
    Mexico's economy contracted for the first time in four years
in the second quarter and policymakers said growth next year
would also likely be weaker than policymakers had expected.
    "Hence, a wide degree of slack in the economy is expected
for a prolonged period. This points to a path for inflation in
the coming months below the one previously predicted," the
central bank said in a statement accompanying the decision.
    The surprise cut comes just before the government is set to
unveil a proposed tax overhaul that is a key component of a
wider economic reform package. However, higher taxes could
dampen growth and fuel inflation in the short term.
    The central bank said any impact from the tax reform would
be transitory and was unlikely to spur knock-on effects on
prices.

 
    
    Bond prices surged after the move, driving down yields
sharply while stocks pared early losses to rise around 1
percent on expectations that lower borrowing costs would help
companies better weather the current soft patch in the economy.
    The central bank gave few hints on whether it was planning
to keep cutting interest rates but analysts said they had left
the door open to another cut if growth continues to falter.
    "Mexican data is going to keep being bad, so you cannot rule
out another cut," said Salvador Orozco, a strategist at
Santander in Mexico City. Barclays called for another 25 basis
point cut in October and Citigroup-unit Banamex also said there
could be another move lower if proposed tax hikes are modest.
    Still, other analysts said stronger growth in the United
States, Mexico's top trading partner, could help Mexico's
economy and make another cut unlikely. The finance ministry has
said it is expecting a pickup in the second half of the year.
    
    "ROLLING THE DICE" 
    Cheap dollars spurred a tide of investment into emerging
markets in recent years, but those same markets have been
punished since May on concerns that U.S. stimulus could be
reduced. Mexico's peso has lost about 9 percent since then.
    A slowing in bond purchases by the Fed could push up returns
on U.S. assets, draw investment back to the United States and
hurt the depreciating peso even more. That could risk higher
inflation if import prices rise.
    Lower benchmark interest rates in Mexico reduce the appeal
of local assets to yield-hungry investors, and the central
bank's cut could make the peso more vulnerable to a Fed move.
    "They are rolling the dice in this sense," said Enrique
Alvarez, an analyst at IDEAglobal in New York, who said
policymakers are betting they can navigate a wind-down by the
Fed and come out with stronger growth in the end. "So I think it
is a good risk to run. It is a calculated risk."
    The peso's  recovery on Friday signaled many
investors were comfortable with the risk the bank was taking. 
    After growth contracted in the second quarter, the
government slashed its growth outlook to 1.8 percent this year
from a previous 3.1 percent estimate.
    Meanwhile, inflation has fallen back below the central
bank's ceiling of 4 percent and policymakers said weak growth
would help further cool price pressures.
    Mexico's central bank cut its benchmark rate for the first
time in nearly four years in March in what was seen as a bid to
curb massive foreign investment flows. But policymakers then
held rates steady after a surge in some fresh food prices drove
inflation above 4 percent.
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