UPDATE 2-Mexico annual inflation eases in January

(Recasts, adds detail, background and byline)

MEXICO CITY, Feb 7 (Reuters) - Mexican annual inflation fell to 3.70 percent in January, down 6 basis points from the prior month, raising expectations of an interest rate cut, thanks to slower-rising tortilla prices.

Headline inflation in January was 0.46 percent.

Core inflation, which strips out some volatile food and energy prices, was 0.40 percent, with annual core inflation at 4.06 percent, down 8 basis points from December, the central bank said in a report.

The central bank said tortilla prices contributed less to inflation in January than in the year-ago period, when they were hit hard by a spike in the price of corn and other grains.

Economists in a poll on Wednesday had predicted on average that January headline inflation would come in at 0.54 percent.

Rising prices for housing, electricity and beer pushed the consumer price index higher in January, while lower prices for tomatoes, vacations and oranges helped contain inflation, the bank said.

Last week, the central bank held steady its consumer price forecast for the next two years, as a slowing U.S. economy compensates for higher international grain and dairy prices, which have been fueled by soaring demand in Asia.

It forecast inflation would be between 3.75 percent and 4.25 percent in the first quarter of this year. January’s reading is already just below expectations.

UBS economist Guillermo Aboumrad said inflation below the central bank’s forecast range is one of two preconditions needed for the bank to cut interest rates.

“The combination of inflation below the central bank’s forecast ... plus a strong currency is a recipe for rate cuts,” Aboumrad said. He said the peso would have to strengthen a bit more before the bank cuts.

“Everything is moving in the direction of cuts,” Aboumrad said.

Central bank Guillermo Ortiz told reporters on Thursday the January inflation data was within expectations but warned that grain prices will probably stay high, despite the U.S. downturn.

“The duration and intensity of this upward swing ... will probably be higher and last longer than in other cycles,” Ortiz told reporters.

The bank expects annual inflation to rise to as high as 4.5 percent this year before possibly reaching the bank’s 3 percent target by the third quarter of 2009.

After the U.S. Federal Reserve slashed U.S. interest rates aggressively last month, investors have increased bets Mexico’s central bank will follow suit and cut its key rate this year.

A looming U.S. recession that is also expected to dent Mexico’s economic growth led Mexico’s government to cut its 2008 growth forecast to 2.8 percent from 3.7 percent last week.

Slow U.S. expansion is bad news for the economy in Mexico, which sends about 80 percent of its exports to its northern neighbor.

In December, Mexican consumer prices rose 0.41 percent, and core inflation was 0.46 percent.

Additional reporting by Jason Lange; Editing by Diane Craft