MEXICO CITY Mexico's surprise interest rate cut shows policymakers are worried that the peso could overheat in coming years, despite their hands-off attitude toward the currency in public.
The Banco de Mexico cut interest rates by 50 basis points despite rising inflation, a move that goes against orthodox arguments that lower interest rates can fan price pressures.
The central bank is staking its credibility that inflation in Latin America's second-largest economy has been tamed and will reach the bank's 3 percent target in the longer term, betting it can cut without putting pressure on prices.
Central bank chief Agustin Carstens is mindful of a potential acceleration in foreign investment in Mexico that could supercharge the peso and set the currency up for a painful slump once rates rise in advanced nations and flows reverse.
The reverse-engineered argument is about cushioning the economy now against the risk of a future currency shock that could upset even the most well-behaved inflation trend.
"If you lower the incentives to invest today, then the outflow will be lower in the future. So lower interest rates now mean lower inflation in the future," said Banorte-Ixe analyst Gabriel Casillas, who was one of the few to predict the cut.
"It is tough to see it since usually lower rates don't mean lower inflation."
Major economies around the world are tackling weak growth with unorthodox policies to boost money supply, with the Bank of Japan the latest to join the so-called "currency wars."
Bracing for a flood of yield-seeking capital, emerging markets such as Turkey, Poland, Hungary and India have all cut rates in recent months in moves at least partly aimed at fending off speculative inflows, and Banco de Mexico fears more to come.
"The considerable additional monetary easing expected in many advanced and emerging economies could lead to increased capital flows to our country and a concomitant relative unnecessary tightening of monetary conditions," said the central bank, which, unlike its peers, has eschewed currency intervention.
A stronger peso drags on growth by making exports more expensive. Although the peso is weaker now than it was before the financial crisis, at 12.62 per dollar it is stronger than the 13-13.50 level manufacturers say they prefer.
Carstens warned in January of a "perfect storm" formed from the combination of massive inflows to some countries, potential asset price bubbles and the risk of major economies unwinding their stimulus measures and causing flows to reverse.
A surprise pick-up in U.S. jobs growth in February - announced 1-1/2 hours before Mexico's rate decision was published - fanned bets the Federal Reserve may start reversing bond purchases and raise rates sooner than expected. However, traders do not see changes until early 2015.
Mexico has absorbed $160 billion in new foreign investment in its financial markets in the last three years, pushing stocks .MXX and bonds to record highs.
Foreign holdings of Mexican peso debt have surged six-fold since 2008 to 1.6 trillion pesos ($128.6 billion), 37 percent of the total on issue, from 13 percent at the time of the last foreign capital outflow in 2008-2009.
At that time, foreign holdings fell by a quarter in the space of seven months, pushing the peso down nearly 30 percent. A similar fall in the peso now would take it to 18 per dollar.
The peso touched its highest level in nearly a month following Friday's rate cut, the opposite reaction to what would normally be expected. But traders said it was also helped by the strong U.S. numbers, which could bode well for Mexican exports.
The reaction could also be a sign markets believe the central bank's argument that lower rates will not lead to a spike in inflation, even though inflation has never stayed at 3 percent for longer than one month since 2001.
Unlike other Latin American markets, Mexico enjoys a combination of healthy public finances and liquid, open markets, and growth is still seen at 3.5 percent this year.
Carstens may also be worried about over-confidence in the new government's hopes to break 15 years of legislative deadlock and pass key economic reforms - echoing the optimism that turned Brazil into an investors' darling in the last decade.
Foreign inflows strengthened Brazil's currency to the point that it choked local manufacturers as they were buffeted by a wave of cheaper imports. Brazil reacted with capital controls and lower rates, but now inflation has soared.
"We believe the real reason behind the cut was the potential for peso appreciation once reforms get approved," Nomura analyst Benito Berber wrote in a note to clients, saying the bank's inflation argument was weak. "Banxico might just have lost some of its hard-won credibility, in our view."
There are doubts whether lower rates will keep investors at bay, given all the reasons to keep investing in Mexico.
"On fundamentals you would probably still favor Mexico over its neighbors," said Frances Hudson, global strategist with Edinburgh-based Standard Life, which manages $260 billion in assets worldwide.
Even though the central bank said it was a one-off cut, some fund managers and analysts said if the ploy does not work, policymakers would not hesitate to lower rates again.
"More rate cuts will come if the peso strengthens and as long as the consumer price index behaves," said Edwin Gutierrez, who helps manage $11 billion in emerging market debt at Aberdeen Asset Management in London.
(Editing by Dan Grebler)