Little do they know that lowering rates removes interest income from the economy and on the supply side lowers costs and lowers forward prices, thereby reducing inflationary forces…

Mexico central bank unexpectedly cuts rate to spur weak economy

By Michael O’Boyle and Alexandra Alper

June 6 (Reuters) — Mexico’s central bank unexpectedly slashed interest rates to a record low on Friday, saying a sluggish economy gave it room for a one-off cut to spur growth without fanning inflation pressures.

The Banco de Mexico cut its benchmark interest rate by 50 basis points to 3.00 percent, surprising 21 analysts who had unanimously forecast in a Reuters poll that rates would stay on hold.

Latin America’s No. 2 economy barely grew in the first quarter as a harsh winter dragged on growth in the United States, Mexico’s top trading partner, while Mexican tax hikes hit domestic demand.

“Given the greater margin of slack in the economy, the efficient convergence of inflation towards 3 percent is feasible with a lower reference interest rate,” the central bank said in a statement.

Policymakers said they did not expect to further cut rates, suggesting even lower borrowing costs would not be prudent since the United States is expected to begin a tightening cycle and growth in Mexico is forecast to pick up.

The bank’s move stunned markets. Traders reported chaos on trading floors. Mexican bond yields tumbled and the stock market rose to its highest level this year, while the peso currency briefly hit a session low.

Prices for the county’s benchmark 10-year peso bond jumped, pushing down its yield by 33 basis points in the biggest one-day drop since last September. “Banks were really caught off guard,” said one Mexico-based bond broker. The cut was surprising given the bank’s conservative reputation. Analysts speculated the decision was split, reasoning that Gov. Agustin Carstens likely pushed for a bold cut, overriding concerns of other board members about inflation.

In its decision, the central bank said inflation risks have lessened. Annual inflation has been falling since it spiked above the central bank’s 4 percent limit in January, largely due to new taxes on soft drinks and fast food.

But policymakers said there were still risks that economic growth could slow after a weaker-than-expected start to the year. Last month the government cut its estimate for annual growth in 2014 from 3.9 percent to 2.7 percent.

The central bank said despite stronger exports, it was still worried about weakness in domestic spending.

The country’s central bank had not been expected to lower its main rate so far below the current inflation rate, which was 3.44 percent in the 12-month period though mid-May.

In previous years, sharp drops in the peso currency have made Mexican interest rate cuts risky since lower borrowing costs could push yield-hungry investors to dump Mexican fixed income assets and further hurt the currency.

A weak currency can spur inflation through higher import prices. Analysts said the central bank was taking advantage of renewed calm in financial markets and the recent dip in inflation to shore up economic growth.

“They seized the moment,” said Delia Paredes, an economist at Banorte bank in Mexico City. “It was quite a surprise.”