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Summary of "Mexico: Risks from FX to inflation"

Core Content

This document provides an analysis of the potential impact of currency depreciation on inflation in Mexico, focusing on the exchange rate pass-through (FX pass-through) effect and its implications for monetary policy and inflation outlook in 2018. The study updates and replicates models used by Banxico (Mexico's central bank) to assess how changes in the peso (MXN) could influence consumer price inflation (CPI) and core inflation subgroups.

Main Points

FX Pass-Through to Inflation

• Banxico's estimates: The central bank estimates that a 1% change in the MXN leads to a 0.05pp impact on overall CPI.
• Depreciation only: When considering only depreciation rounds, the impact increases to 0.09pp.
• Output gap effect: The impact is diminished when the output gap is open, as is currently the case, with the pass-through coefficient estimated at 0.004 (not statistically different from zero).
• BNP Paribas estimates: The pass-through coefficient is estimated at 0.04 for overall CPI and 0.06 for depreciation-only scenarios, with the output gap effect reducing it to 0.05.

2018 Inflation Outlook

• Base-case scenario: The peso is expected to trade at 18, leading to a CPI inflation of 3.5% in 2018.
• Stress scenario: If the peso weakens to 22 and remains there, CPI inflation could rise by 1.3pp to 4.8%.
• Core CPI: The pass-through coefficient for core CPI is estimated at 0.05, with core goods (ex-food) showing a higher sensitivity to FX changes.

CPI Composition and FX Impact

• Non-core components: These, including energy and fresh food items, are most affected by FX movements. They make up around 23% of the CPI basket.
• Processed foods: Highly sensitive to FX, with a pass-through coefficient of 0.06, and their weight in the CPI basket is expected to increase to 21.2% in 2018.
• Fruits and vegetables: Show a high FX elasticity (0.44), which could amplify inflation risks if the peso weakens.
• Livestock: Less sensitive, with a pass-through coefficient of 0.10.

Policy Considerations

• Monetary policy tools: Banxico is more likely to use FX hedging programs rather than rate hikes to manage inflation risks.
• Rate hike threshold: The bar for a rate hike is high, and it would require significant and sustained depreciation to impact inflation expectations.
• Base-case policy rate: BNP Paribas expects Banxico to cut rates from 7% to 5% by end-2018 in the base-case scenario.

Key Risks

• Peso depreciation: A significant weakening of the peso could increase inflation by 1.3pp in 2018.
• Inflation expectation dynamics: If FX weakness undermines inflation expectations, it could trigger a more aggressive policy response.
• Food price volatility: The increased weight of food items in the new CPI basket (effective August 2018) may lead to more inflation volatility.

New CPI Basket

• Effective August 2018: The new basket will increase the weight of core food components by 6pp.
• Impact on volatility: While the pass-through coefficient for core food is close to headline inflation, the increased weight could lead to greater CPI volatility.

Policy Credibility and Inflation Expectations

• Inflation targeting: Mexico's adoption of an inflation targeting regime has helped anchor inflation expectations.
• Stable expectations: Despite a current CPI inflation of ~7%, medium- and long-term expectations remain below the 4.0% policy tolerance.
• Empirical evidence: Studies show pass-through coefficients to overall inflation below 0.10pp, supporting the view of a low impact.

Conclusion

The analysis suggests that while FX depreciation could have some inflationary impact, the overall effect is limited due to policy credibility and the structure of the CPI basket. The base-case scenario for 2018 assumes a weaker peso (18) and lower inflation (3.5%), with a likelihood of rate cuts. However, risks remain, particularly if the peso weakens significantly or if food price volatility increases.