Monetary Policy under Fed Normalization and Other Challenges...Monetary Policy under Fed Normalization and Other Challenges 2 The favorable recent performance of the global economy

Monetary Policy under Fed Normalization and Other Challenges

Santander Latin America Day London, June 28th, 2018

Javier Guzmán Calafell, Deputy Governor, Banco de México*

*/ The opinions and views expressed in this document are the sole responsibility of the author and do not necessarily represent the institutional position of the Banco de México or of its Board of Governors as a whole.

Monetary Policy under Fed Normalization and Other Challenges 2

The favorable recent performance of the global economy supports the expectationof a further, albeit moderate, strengthening over the rest of this year and the next,with growth rates at levels above the estimated potential.

However, downside risks for this scenario persist, and some of them haveaccentuated recently.

o Potential for further restrictions to international flows of goods and services.

o Possibility of a faster-than-anticipated normalization of monetary policy in theUnited States.

o Risk of mounting geopolitical tensions in multiple regions, coupled with politicaland electoral developments in several countries.

In this context, international financial markets have displayed in recent weeksincreased volatility and diminished risk appetite.

This has resulted in capital outflows from EMEs, with a negative impact on theirasset prices.

3

The Mexican economy has shown resilience in a context of shocks, both domestic andexternal. Annual GDP growth has recorded positive figures for 33 consecutive quarters.

Mexico: Gross Domestic ProductAnnual % change, s.a.

s.a./ Seasonally adjusted series.Source: INEGI

-8

-6

-4

-2

0

2

4

6

8

II III IV I II III IV I II III IV I II III IV I II III IV I II III IV I II III IV I II III IV I II III IV I

2009 2010 2011 2012 2013 2014 2015 2016 2017 2018


4

Economic activity strengthened significantly in the first quarter of 2018.This was explained by:

o On the demand side: Growing exports and private consumption, inaddition to an upturn in investment.

o On the supply side: Sustained growth in the services sector, with aslight improvement in industrial activity.

Thus, at the start of the year, GDP growth recorded the highestquarterly rate since July-September 2016.


5

s.a. / Seasonally adjusted series.Source: INEGI.

Such high rates of growth, however, are unlikely to be sustained in coming quarters. Themonthly indicator of economic activity fell in April and investment might not sustain itsrecent dynamism.

Goss Fixed InvestmentIndex 2013 = 100, s.a.

60

70

80

90

100

110

120

130

140

2008 2009 2010 2011 2012 2013 2014 2015 2016 2017 2018

Total Machinery and Equipment Construction

March


Monthly Indicator of Economic Activity (IGAE)% change with respect to the previous period, s.a.

Total

4Q 2017 0.88

1Q 2018 0.68

April 2018 -0.57s.a. / Seasonally adjusted series.Source: INEGI.

6

The recent evolution of industrial output also suggests that the impact of transitoryfactors is beginning to fade.

Industrial ProductionIndex 2013 = 100, s.a.



70

75

80

85

90

95

100

105

110

115

2008 2009 2010 2011 2012 2013 2014 2015 2016 2017 2018

Total Mining Manufactures Construction

April

7

It is also important to take into account that, in previous electoral periods, it is frequentto observe upturns in economic activity during the first half of the year, which tend torevert, at least partially, over the second half.

Gross Domestic Product% change with respect to the previous period, s.a.



1.8

2.7

2.4

1.6

3.2

1.3

1.9

3.1

0.9

2.5

1.41.5

0.0

0.5

1.0

1.5

2.0

2.5

3.0

3.5

2H 1H 2H 2H 1H 2H 2H 1H 2H 2H 1H 2H

1993-1994 1999-2000 2005-2006 2011-2012

1.3

1.7

2.1

2.5

2.9

Jan-17 Feb-17 Mar-17 Apr-17 May-17 Jun-17 Jul-17 Aug-17 Sep-17 Oct-17 Nov-17 Dec-17 Jan-18 Feb-18 Mar-18 Apr-18 May-18 Jun-18

Memo: 2017 (Actual) 2018 2019

June

8

Although, in principle, a faster-than-expected expansion of GDP last quarter would givesupport to improved expectations for 2018 as a whole, the extent to which the fading ofthe above-noted factors affects economic activity going forward remains to be seen.

Real GDP Growth ExpectationsAnnual %

Source: Banco de México and Citibanamex.


Banco de México Forecasts

2018 2.0 – 3.0

2019 2.2 – 3.2

9Monetary Policy under Fed Normalization and Other Challenges

Economic performance in Mexico through 2018 has kept conditions inthe labor market tight.

o Current estimations suggest that the unemployment rate issignificantly below long-term levels.

This might not accurately reflect prevailing conditions in this market,especially in light of the absence of excessive wage pressures or thosethat could be expected from the demand side in a situation of thisnature.

The size of the informal sector adds to the difficulties involved inaccurately assessing slack in the labor market.

10Monetary Policy under Fed Normalization and Other Challenges

The situation in the labor market seems more compatible with current estimations ofthe output gap, which place it at levels close to zero.

Output Gap Projections% of potencial GDP, s.a.

s.a. / Seasonally adjusted series.Source: Banco de México.

-6

-5

-4

-3

-2

-1

0

1

2

3

4

5

6

-6

-5

-4

-3

-2

-1

0

1

2

3

4

5

6

Q2 Q4 Q2 Q4 Q2 Q4 Q2 Q4 Q2 Q4 Q2 Q4 Q2 Q4

Observed

Central Scenario Previous Report

Central Scenario Current Report

11

The recent evolution of 3 out of the 4 sets of variables used by the Banco de México to estimate monthly indicators of slack in the economy also supports this conclusion.

Consumption

First Principal Components%

Economic Activity and Aggregate Demand Demand Conditions in the Loanable Funds Market

Labor Market

Source: Banco de México.


-6

-4

-2

0

2

4

2007 2008 2009 2010 2011 2012 2013 2014 2015 2016 2017 2018

-4

-2

0

2

4

2007 2008 2009 2010 2011 2012 2013 2014 2015 2016 2017 2018

-6

-4

-2

0

2

4

2007 2008 2009 2010 2011 2012 2013 2014 2015 2016 2017 2018

-4

-2

0

2

4

2007 2008 2009 2010 2011 2012 2013 2014 2015 2016 2017 2018

0

1

2

3

4

5

6

7

8

9

10

11

12

13

2015 2016 2017 2018 2019 2020

Headline

Headline (Quarterly Average)

Core

Non-Core

Banco de México Forecast (Headline)

Variability Interval

June*

12

Contributions to CPI InflationAnnual %, %-points and %

*/Data through the fist fortnight of June 2018.Source: Banco de México and INEGI.

Inflation continues to display a downward trend which, although less pronounced than inthe first months of the year, remains compatible with the trajectory foreseen by Banco deMéxico.

December 2017

June* 2018

Difference

Headline CPI 6.77 4.54 -2.23

Contributions (%):

Core 4.87 3.59 43.0

Non-Core 12.62 7.41 57.0

CPI InflationAnnual %


13


In addition, core inflation has declined to levels below the upper limit of the variabilityinterval around the target. Meanwhile, fundamental core inflation, which tends to bemore closely associated with the economic cycle, has fallen during the year, and remainsbelow core inflation.

Core and Fundamental Core InflationAnnual % change


0

1

2

3

4

5

6

7

8

2007 2008 2009 2010 2011 2012 2013 2014 2015 2016 2017 2018

Core Fundamental Core

June*

14


Furthermore, nearly half of the CPI basket shows annualized growth under 3 percent asof the first fortnight of June this year.

Percentage of the CPI Basket According to Intervals of Monthly Annualized Increment%, s.a.

CoreHeadline


0%

10%

20%

30%

40%

50%

60%

70%

80%

90%

100%

2014 2015 2016 2017 2018

Less than 2% Between 2 and 3%

Greater than 3 and up to 4% Greater than 4%

Less than or equal to 3%

June*0%

10%

20%

30%

40%

50%

60%

70%

80%

90%

100%

2014 2015 2016 2017 2018

Less than 2% Between 2 and 3%

Greater than 3 and up to 4% Greater than 4%

Less than or equal to 3%

June*


15

Survey-based inflation expectations at all horizons remain relatively stable. However, theyare above both Banco de México’s projections and the 3 percent target. In addition, inflationbreakevens increased in recent weeks, which suggests more market concern about thetrajectory of inflation in the medium to long terms.

Inflation Breakevens1/

Basis Points

1/ Difference between yields on nominal and real (inflation-protected) bonds. In addition to expected inflation, thismeasure includes other (e.g. inflationary, liquidity and term) risk premia.Source: Banco de México with data from PiP.

Short- and Long-Term Inflation ExpectationsAnnual %

Source: Citibanamex.

2.5

3.0

3.5

4.0

4.5

5.0

5.5

6.0

6.5

2014 2015 2016 2017 2018

End 2018 End 2019

Next 2-6 Years Permanent Target

June


230

265

300

335

370

405

440

475

510

Jan-16 Mar-16 Jun-16 Sep-16 Dec-16 Mar-17 Jun-17 Sep-17 Dec-17 Mar-18 Jun-18

3 Years

10 Years

30 Years

June

16

A number of factors may adversely affect the foreseen trajectory forinflation in coming months.

o The recent performance of the peso-dollar exchange rate, as well asthe perspective of prolonged NAFTA negotiations, may imply a moredepreciated exchange rate for the rest of the year.

o Futures markets suggest additional pressures from the evolution ofgasoline and domestic gas prices.

o Recent tariffs to imports of some items from the United States willhave an impact on prices.

In view of the above, the convergence of inflation to the target maytake longer than previously expected.


17

Thus, the balance of risks for inflation is tilted to the upside.

o As in recent months, the main risk comes from the exchange rate, asit can be affected, among other factors, by the negotiation of NAFTA,the electoral process in Mexico, and interest rate increases in the US.

o In view of tight conditions prevailing in the labor market, demandpressures on prices cannot be disregarded.

o Increases in the prices of non-core items can materialize, given theirhigh volatility.

o The likelihood of inflationary pressures from greater globalprotectionism has increased, especially in light of recent messagesand actions from the part of the US government.


18

The peso has depreciated significantly since mid-April. This is partly explained by theappreciation of the dollar, but idiosyncratic factors are also behind this trend.

Note: The countries included in the average for EMEs are Argentina, Brazil, Chile, Colombia, Hungary, Indonesia, Mexico, Peru, Philippines, Poland, Russia, South Africa, South Korea and Turkey.Source: Banco de México with data from Bloomberg.

Appreciation

Depreciation

EME Currency Performance in 2018Index 31-Dec-2017 = 100


80

85

90

95

100

105

110

1-Jan-18 23-Jan-18 14-Feb-18 8-Mar-18 30-Mar-18 21-Apr-18 13-May-18 4-Jun-18 26-Jun-18

Range

Mexican Peso

EME Average

June

19

Operating conditions in the foreign exchange market have deteriorated, although they remain within adequate ranges.

1/ Change in the USD/MXN per USD million traded.Source: Banco de México with data from Reuters Source: Banco de México with data from Reuters

Market DepthCents of Mexican Peso1/

Bid-Ask SpreadCents of Mexican Peso

FX Market


Less Depth

More Depth0.0

0.1

0.2

0.3

0.4

0.5

0.6

Oct-16 Dec-16 Feb-17 Apr-17 Jul-17 Sep-17 Nov-17 Jan-18 Mar-18 Jun-18

June0.0

0.5

1.0

1.5

2.0

2.5

3.0

Oct-16 Dec-16 Feb-17 Apr-17 Jun-17 Sep-17 Nov-17 Jan-18 Mar-18 Jun-18

June

20

Naturally, interest rates in Mexico have also been affected by a combination of domesticand external factors. In this context, a further widening of differentials with respect to USrates and a flattening of the domestic yield curve have been observed.


Mexico-United States Interest RateSpreads

Basis points

Source: Banco de México with data from Bloomberg.

Slope of the Yield Curve as Measured by the 30-3 Years Government Bond Interest Rate Spreads

Basis points

Notes: Nominal interest rates.Source: PiP and Bloomberg.

400

425

450

475

500

525

550

575

600

Sep-16 Dec-16 Apr-17 Jul-17 Nov-17 Feb-18 Jun-18

3 years 5 years 10 years 30 years

June0

25

50

75

100

125

150

175

200

Sep-16 Dec-16 Apr-17 Jul-17 Nov-17 Feb-18 Jun-18

United States Mexico

June

21

Monetary policy has reacted decisively to actual or potential inflationary pressures sincelate-2015.

Policy Interest Rates%

1/ Data for inflation through the first fortnight of June 2018.*/ Mid-point of the target range.Source: Banco de México, INEGI and Federal Reserve.


0

1

2

3

4

5

6

7

8

2015 2016 2017 2018

Mexico (Overnight Inter-Bank Interest Rate)

Memo: Mexico's Headline CPI Annual Inflation

United States (Federal Funds Rate)*

Inflation Variability Interval

June1/

22

Recent developments imply the materialization of some of the inflationaryrisks identified by the Banco de México several months ago.

Some of them represent changes in relative prices, with a short-term impacton inflation but unlikely to affect long-term inflation expectations. However,in other cases the potential implications are not clear-cut.

Since this is taking place in a context of shocks from several sources, abalance of risks for inflation tilted to the upside and above-normaluncertainty conditions, additional adjustments to the monetary policy stancehave been needed.

Given the prevailing conditions, the Banco de México must continue toadhere to a cautious monetary policy approach and be ready to respondaccording to emerging circumstances. Therefore, the possibility of additionaladjustments to the reference rate cannot be excluded.


23

Naturally, the breadth of the actions required goes beyond monetary policy.

Overall, the Mexican economy has a firm basis to face shocks.

o Fiscal consolidation efforts have turned the primary balance into asurplus since last year, yielding corresponding declines in the publicsector’s debt.

o The current account deficit shows, and is expected to maintain, moderatelevels.

o International reserves are adequate by international standards, andemergency liquidity funding is available through a FCL with the IMF.

o The banking system is well capitalized, profitable and has adequate levelsof liquidity. In general, financial risks of a systemic nature appear absent.

o Despite some increase in recent years, the debt of the private sectorremains at moderate levels


24

In fact, private and total indebtedness in Mexico compare well with other emerging and advanced economies.

Source: IMF.

Private Debt% of GDP (2016)

0

20

40

60

80

100

120

140

160

180

200

220

Ind

on

esia

Mex

ico

Per

u

Ind

ia

Co

lom

bia

Bra

zil

Sou

th A

fric

a

Turk

ey

Po

lan

d

Hu

nga

ry

Ger

man

y

Ital

y

Thai

lan

d

Ch

ile

Mal

aysi

a

Un

ited

Sta

tes

Jap

an

Un

ited

Kin

gdo

m

Fran

ce

Ko

rea

Ch

ina

Can

ada

0

40

80

120

160

200

240

280

320

360

400

Ind

on

esia

Per

u

Mex

ico

Turk

ey

Co

lom

bia

Sou

th A

fric

a

Ind

ia

Po

lan

d

Bra

zil

Ch

ile

Hu

nga

ry

Thai

lan

d

Ger

man

y

Mal

aysi

a

Ko

rea

Ch

ina

Ital

y

Un

ited

Kin

gdo

m

Un

ited

Sta

tes

Fran

ce

Can

ada

Jap

an

Source: IMF.

Total Debt% of GDP (2016)


25

However, the magnitude of the challenges we face underscores theneed of timely and adequate economic policy responses, as well as ofstrengthening the economy’s fundamentals and the institutionalframework.

It is of the utmost importance to keep in mind that we may continue toface a situation of high uncertainty over a prolonged period.

Even under a scenario in which some of the current risks dissipate,others, such as the tightening of external financial conditions, will in alllikelihood be present for an extended time.

In addition, an increase in the economy’s growth potential is needed.


26

It is also important to keep in mind that some, but not all, of the sourcesof uncertainty are outside the authorities’ control.

In particular, as soon as the electoral process is concluded, specificdetails will be required regarding the economic policy actions that theincoming administration intends to take, especially though not only, inthe public finance front.

In this process, it will be essential to keep in mind the risks derived froma very complex external environment and from the openness of theMexican economy to foreign capital flows.


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Monetary Policy under Fed Normalization and Other Challenges...Monetary Policy under Fed Normalization and Other Challenges 2 The favorable recent performance of the global economy