Mexico holds key rate steady, eyes credit crisis

Aug 24, 2007 - Mexico's central bank held its key overnight interest rate steady at 7.25 percent on Friday, as analysts expected, but cautioned it would act if niggling food prices become a threat to its inflation goal.

But in a hint that it may have eased its bias toward worries about inflation, the central bank warned that the U.S. subprime mortgage crisis could lead to a slower economy in the United States, Mexico's top trading partner. The bank said it took that uncertainty into account in its monthly policy review.

Twelve-month inflation, which has been pushed up by higher fruit, vegetable and dairy prices over several months, is seen on path toward the bank's 3 percent target and should be near that goal by the end of 2008, the Banco de Mexico said.

Still, the future trajectory of food prices remains unnerving and the bank said it is worried that medium-term inflation expectations remain above its target.

"The board will continue to evaluate the balance of risks and will act if its deterioration compromises the inflation objective," the bank said.

UBS economist Guillermo Aboumrad, in a telephone interview with Reuters, said the central bank "is equally concerned with international events regarding credit restrictions and with the pace of world food inflation. It's trapped between two worlds."

A slowdown in the United States would hurt Mexico's economy and put pressure on the Banco de Mexico not to raise rates any further.

Mexico's annual inflation ticked up to 4.10 percent in early August, above the central bank's target range but still within expectations.

The bank said last month it expects annual headline inflation between 3.75 percent and 4.25 percent in the third quarter. But 12-month inflation should come back down to between 3.25 percent and 3.75 percent in the fourth quarter, the bank has said.

The bank did not comment about a possible price spike that could be caused by the implementation of a fiscal reform package being negotiated by the government with lawmakers.

While economists have long encouraged a tax overhaul to improve government revenues, they warn that its implementation could cause inflation as products become more expensive because of higher taxes.

Ruling party and opposition lawmakers say they are close to a deal on a tax reform package, which President Felipe Calderon wants passed soon so it can be included in the 2008 budget.

That might tempt the central bank to raise rates, but uncertainty about the U.S. economy will probably keep it in check for now, some analysts say.

"Barring a major unfavorable price shock in Mexico, a stabilization of (U.S.) credit market conditions seems to be a prerequisite for the central bank to tighten," said Credit Suisse economist Alonso Cervera in a report.

The central bank, which tries to keep annual inflation below 4 percent, surprised financial markets with a 25-basis-point interest rate hike in April. It has kept rates steady since then while warning it would hike if price pressures put its long-term inflation goal in danger.

All economists polled by Reuters had expected the central bank to hold steady on Friday.