Mexico's central bank raised its benchmark target for the overnight interbank rate by another 50 basis points to 6.25 percent to anchor inflation expectations and prevent that a drop in the value of the peso spills over to consumer prices and leads to even higher inflation.
The Bank of Mexico (Banxico) has now raised its rate by 325 basis points since the U.S. Federal Reserve's rate hike in December 2015 and by 100 basis points since the election of Donald Trump as U.S. President.
Going forward, the central bank said it would continue to follow all the factors that are influencing inflation along with expectations, and especially the potential transfer of changes to the exchange rate to prices, along with the cost of gasoline, the output gap, and the relative monetary position between Mexico and the U.S.
Mexico's inflation rate jumped to 4.72 percent in January to the highest level since September 2012 , boosted by a rise in energy costs following a government hike in gasoline prices and rising import costs from the lower peso.
Banxico said short-term inflation expectations have risen “significantly” in response to higher energy prices but doesn't expect this to have a widespread impact as medium-term expectations have risen far less while longer-term expectations remain around 3.5 percent.
For the remainder of this year the central bank expects inflation to remain in the upper limit of its target range of 2-4 percent but then converge towards its midpoint target in the final months.
By the end of next year inflation is seen to be temporarily affected by the impact of the deprecation and the liberalization of gasoline prices but generally converge toward the 3.0 percent midpoint target as demand is not expected to exert any upward pressure on inflation.
However, Banxico added that this forecast is subject to the risk that inflation expectations rise even further from additional depreciation of the peso, uncertainty in the external environment and that energy prices rise even further.
Downside risks to inflation stem from a possible appreciation of the peso, lower prices in connection with structural reforms, lower energy prices from greater competition among gasoline suppliers in Mexico and that economic activity decelerates even more than expected.
“The balance of risks are considered to have continued to deteriorate,” the bank said.
Mexico's peso has weakened since November 2014 with its fall accelerating following the election of Trump, who plans to build a wall between the two countries and renegotiate the North American Free Trade (NAFTA) agreement.
But since mid-January the peso has rebounded and rose by 0.5 percent following the latest rate hike to trade at 20.4 to the U.S. dollar, up 1.5 percent this year. But compared with the start of 2016, the peso has depreciated by 15.7 percent against the dollar.
Baxico noted the Federal Reserve left its fed funds rate steady at its meeting last week but added the process of normalizing its monetary stance could take place faster than was expected at the end of last year, partly reflecting the Trump administration's intention to expand fiscal policy through higher infrastructure spending and tax reform.
Mexico's economy rebounded in the fourth quarter of last year as external demand improved and private consumption remained positive.
However, investment remains weak and the relationship between Mexico and the United States could be hampered as part of U.S. policy under Trump, which has already affected consumer and business confidence, foreign direct investment and remittance flows.
“The risk balance of growth continued to deteriorate,” the central bank said.
Mexico's Gross Domestic Product grew by an annual rate of 2.2 percent in the fourth quarter of 2016, up from 2.0 percent in the third quarter but down from 2.6 percent in the second.