(Courtesy the Bank of Mexico)
Summary
The world economy continued to recover during the first
quarter of 2010 more rapidly than anticipated, although
differently among regions and countries. Advanced
economies have grown at a considerably more moderate
rate than emerging economies and continue to depend to a
great extent on the stimulus from accommodative macroeconomic
policies. The rebound of these economies has also relied on the
growth of net exports and, in general, on the recovery of inventories.
Showing sound economic fundamentals, emerging economies have
benefited from the expansion of foreign trade as well as the strong
world demand for commodities.
Conditions in international security markets have gradually returned to
normal. In particular, access conditions to these markets regarding
costs and terms have rapidly recovered. Nevertheless, bank lending is
still weak, particularly in advanced economies. Thus, the sustainability
of the recovery of international economic activity will mainly depend on
the banking sector’s capacity to refinance itself, and to strengthen its
balances and grant credit to the private sector.
Inflationary pressures have been contained in most advanced
economies, basically as a result of lower than potential production, the
consequent idle capacity, and the high levels of unemployment in
these economies, which have contributed to maintain inflation
expectations low and stable. In light of the need to continue boosting
the recovery and improvement of financial systems, the central banks
of these economies decided to leave their monetary policy stances
unchanged. In contrast, emerging economies which where less
affected by the global crisis and therefore exhibit less slackness in
their economies, have started to withdraw their monetary and credit
stimuli.
Emerging economies continued registering high capital inflows, partly
as a result of expectations of interest rate spreads relative to
advanced economies remaining high in the near future. Prospects of a
continuous appreciation of their exchange rates and higher growth in
relation to advanced economies have also contributed to this
phenomenon. In fact, the extremely accommodative monetary and
fiscal policy stance in advanced economies is a factor that could
complicate macroeconomic management in emerging economies.
In Mexico, manufacturing production continued following a positive
trend during the first quarter of 2010. The greater dynamism of
industrial activity in the U.S. contributed to such a trend, which also
raised the trade volume of Mexican exports. In contrast, domestic
expenditure has rebounded at a slower pace, especially private
investment, which has hardly recovered. Under these conditions, the
economy continues operating below its productive potential level.
Annual headline inflation rose from 3.98 percent on average during
the fourth quarter of 2009 to 4.75 percent during the first quarter of
2010, placing itself in the upper limit of the forecast interval published
by Banco de México in the Addendum to the Inflation Report of July-
September 2009 in November of that year. Upward pressures on
headline inflation concentrated mainly on the CPI’s non-core
component, given that the core component –which reflects to a
greater extent the medium-term inflation trend– decreased. The
increase in non-core inflation was affected by the resetting of the
policy of monthly fuel price adjustments and changes in prices and
fares determined by local governments, as in the case of the subway
and water supply services in Mexico City. This pattern was also
influenced by the extraordinary rise in the prices of certain vegetables
originated by the adverse weather conditions that affected their
production. As for core inflation’s reduction, it was driven by the
exchange rate appreciation which lessened the impact of the recent
tax adjustment on prices, in an environment where wages adjusted
moderately and medium and long-term inflation expectations
remained relatively stable.
Under this environment, up to now, Banco de México’s Board of
Governors has kept its target for the Interbank Interest Rate
(operational target) at 4.5 percent.
Banco de México foresees the following macroeconomic base
scenario for the Mexican economy:
GDP Growth: the improvement in the outlook for industrial production
growth in the U.S., together with the recent development of Mexican
economic activity, suggests that GDP in Mexico will grow above
previous quarters’ forecasts. In particular, the Mexican economy is
expected to grow between 4.0 and 5.0 percent during 2010. In 2011,
GDP is expected to grow between 3.2 and 4.2 percent, just as
forecasted in the Inflation Report of the previous quarter.
Despite the recovery of productive activity foreseen in this scenario,
slackness is anticipated to prevail in the Mexican economy during
2010. Nevertheless, as a result of the upward revision in growth
expectations for both Mexico and the U.S., these conditions are
expected to fade more rapidly than expected. Indeed, it is likely that
the output gap closes relatively faster than as forecasted in the
previous Report, therefore increasing the probability of certain
scenarios of output gap becoming positive during the first half of 2011.
Employment: the number of IMSS-insured workers is expected to
increase between 500 and 600 thousand in annual terms in both 2010
and 2011.
Current Account: the scenario for domestic demand and productive
activity foreseen for 2010 is anticipated to be reflected in a deficit in
both the trade balance and the current account of 11.5 and 11.9 billion
U.S. dollars in both cases (1.1 percent of GDP), as compared with the
4.7 and 5.2 billion dollar deficit in the trade balance (0.5 percent of
GDP) and in the current account (0.6 percent of GDP).
Since resources availability in international financial markets has
improved, the Flexible Credit Line with the International Monetary
Fund of approximately 48 billion U.S. dollars was renewed, and the
expected repayment of public and private sector’s debt has been
distributed in time, the economy is not expected to face foreign
financing problems in 2010.
The foreseen scenario for economic growth in Mexico for the next two
years is not risk-free. In this regard:
i) The effect that withdrawing both fiscal and monetary stimuli in
advanced economies could have on the recovery of the world
economy and on emerging economies’ access to financing.
ii) In the short run, tighter conditions in sovereign debt markets could
arise, in light of a possible contagion from countries facing fiscal
difficulties.
iii) If the appreciation of the exchange rate continues, export
dynamics would be affected and therefore the capacity of the
economy to recover. The latter, inasmuch as this appreciation
does not reflect the progress in relative productivity of the sector of internationally-traded goods, which would lower production
costs in this sector.
Inflation: the forecast for annual headline inflation for 2010 and 2011
remains unchanged as compared with that of the last two Inflation
Reports (Table 1). This is due to the following:
1. The effect on inflation of the tax increases has been as expected
and up to now no second-round price increases have been
observed.
2. The impact on inflation of the resetting of the policy of monthly
increases in fuel prices as well as of price and fare increases of
local governments, has been consistent with what was
anticipated.
3. Wages are expected to continue adjusting moderately.
4. Medium and long-term inflation expectations remain relatively
stable, although above the 3 percent target.
5. Given the volatility of vegetable prices, their impact on inflation is
expected to be short-lived.
6. Productive activity is anticipated to remain below its potential level
in the following quarters. As a result, no inflationary pressures
from the aggregate demand side are expected.
Base Scenario for Annual Headline Inflation1/
Quarter Quarterly average (percent)
2010-I 4.75
2010-II 4.50 - 5.00
2010-III 4.75 - 5.25
2010-IV 4.75 - 5.25
2011-I 4.50 - 5.00
2011-II 3.50 - 4.00
2011-III 3.25 - 3.75
2011-IV 2.75 - 3.25
2012-I 2.75 - 3.25
Quarter
Forecast
Inflation Report
I-Q 2010
4.75 2/
1/ The forecast of this Report coincides with that of the previous one and
also includes that for the first quarter of 2012. The Inflation Report’s
forecast up to the fourth quarter coincided with that of the Addendum to
the Inflation Report of the third quarter. In each Inflation Report, the
forecast horizon covers the following 8 quarters. For this reason, on
each occasion, one quarter (the eighth) is added to the forecast, as
compared with the first quarter of the previous Report, where it becomes
an observed figure.
2/ Observed figure.
It is important to point out that although the fiscal changes
implemented entail costs regarding short-term inflation, they will also
be beneficial for the good functioning of the economy. Mexico is a
country with a huge need for public spending in both physical and
human capital investment. Financing this type of spending through
stable sources of income is crucial to maintain a macroeconomic
environment characterized by low and stable inflation.
The forecast for annual inflation is subject to various risks, among
which the following stand out:
i) A sudden reversal in capital flows could lead to an abrupt and
rapid exchange rate adjustment.
ii) The possibility that the economic recovery process is more (less)
vigorous than previously anticipated could increase (reduce)
inflationary pressures from the demand side.
iii) As recently observed, the high volatility of fruits and vegetables
prices.
Despite these risks, others have eased in the last months. In
particular, the possibility that a greater pass-through to prices related
to both fiscal changes and public price and fare increases has
diminished, as well as that of a greater rate of adjustment in goods
and services with administered and regulated prices.
After analyzing the development of inflation in Mexico over the last
years, as well as its outlook for the following ones, the following
thought arises. It is well known that inflation is a monetary
phenomenon and therefore central banks are entailed to fight it.
However, in the short term many other factors might affect inflation
and make difficult the attainment of the inflation target set implicitly or
explicitly by the central bank or by society itself. In this regard, it is
clear that a key element to maintain low and stable inflation is sound
public finances.
Nevertheless, various microeconomic policies can also affect inflation
dynamics. Two particularly relevant issues in this regard are the
degree of economic competition and the presence of labor market
rigidities.
First, besides preventing resources from being allocated efficiently
and modern technologies from being adopted more rapidly -which
consequently hampers productivity and economic growth- the lack of
competition leads to excessively high prices of inputs and finished
goods, affecting the distribution of income and magnifying rigidities in
the inflationary process. This, in turn, can make more difficult the
convergence of price growth to the central bank target.
Second, the lack of flexibility in the labor market not only complicates
labor mobility towards its more productive uses, but also translates
into higher labor costs, which also leads to higher prices of various
goods and services produced in Mexico.
It is precisely this type of measures and not the fluctuations in the
nominal exchange rate that will ensure the Mexican economy remains
competitive.
Under this setting, it is crucial to promote both market competition and
flexibility in allocating labor. The approval of the draft proposal to
reform the Law on Economic Competition and the Labor Law currently
under discussion would be a significant step in this direction.
Finally, regarding monetary policy, Banco de México’s Board of
Governors will carefully monitor the trajectory of medium and long-
term inflation expectations as well as other determinants of inflation
that may signal unexpected and widespread pressures on prices. In
particular, it will remain attentive of how fast the output gap closes so
that the central bank adjusts monetary policy in order to attain the 3
percent inflation target by the end of next year.
