Mexico’s central bank wrong-footed economists and boosted the peso by unexpectedly increasing borrowing costs for the first time since late 2018, after inflation remained way above target.

In a split decision, Banco de Mexico raised its key rate by a quarter-point to 4.25% in response to a jump in inflation that policy makers had described as transitory. The decision, supported by three of its five-member board, surprised all 23 economists surveyed by Bloomberg, who had expected the bank to hold at 4%.

The Mexican peso rallied as much as 2.4% after the announcement, leading emerging markets currency gains. Swap rates, which have already been advancing over recent weeks on the back of higher inflation and tightening expectations, also got an extra boost from the decision, with the two-year benchmark climbing close to half a percentage point on the day to reach 6.19%.

Data published Thursday morning showed that inflation accelerated further in early June to 6.02%, also surprising analysts, who expected a minor slowdown. Banxico, as the central bank is known, targets inflation at 3%, plus or minus 1 percentage point.

MEXICO REACT: No Tightening Cycle, But Additional Hikes Possible

Banxico Responds

Mexico's central bank raises key rate for first time since 2018

Sources: Banco de Mexico, INEGI.

`Yr-end 2021 forecast'=Banxico montly survey of economists

“Although the shocks that have affected inflation are expected to be of a transitory nature, given their variety, magnitude, and the extended time frame in which they have been affecting inflation, they may pose a risk to the price formation process,” Banxico’s board said in the statement accompanying the announcement.

The unexpected speed of the price increases are explained by pandemic-driven shocks in supply chains and economic output, it said, adding that a drought affecting Mexico also put pressure on agricultural and livestock prices. The bank now estimates headline inflation to converge to the 3% target during the third quarter of next year, a quarter later than previously forecast.

“The move opens the possibility of another 25 basis-point hike,” said Gabriela Siller, director of economic analysis at Grupo Financiero BASE. “If inflation continues above 5% and above longterm expectations, we could see another hike probably in July or August.”

With the announcement, Mexico joins a group of countries including Brazil, Russia and Turkey that boosted their borrowing costs this year as the exit from the worst of the pandemic led to faster price increases amid the economic recovery.

Mexico Surprise

The central bank unexpectedly raises its benchmark rate

Source: Bloomberg

Note: Mapped data show rate changes for distinct central banks

Easing Reversal

The decision also ends a monetary easing cycle that started in August 2019, which had led to a 425 basis-points reduction in the reference rate. The conditions have changed compared to last year as the economy is now growing and inflation is double the bank’s goal, Jonathan Heath, one of Banxico’s board members, said.

“It’s not the same monetary position,” he wrote on a Twitter post.

Mexico’s economy shrank 8.2% last year, the most in almost a century, and the bank’s easing has provided the only substantial form of economic stimulus during the crisis as the government kept an austere fiscal policy. The economy has rebounded faster than expected so far in 2021, adding to inflationary pressures, with the bank projecting 6% growth for the year.

Annual inflation peaked in April at 6.1% and has barely eased since then. On top of supply shocks, prices have also been driven up by big demand from the U.S., Mexico’s main trading partner.

Thursday’s decision is the first since President Andres Manuel Lopez Obrador nominated Finance Minister Arturo Herrera to become Banxico governor when current leader Alejandro Diaz de Leon steps down at the end of the year.

Further rate increases will depend on how inflation behaves, according to Alonso Cervera, chief Latin America economist at Credit Suisse Group AG.

“If inflation turns out to be temporary, the central bank may be on hold. If inflation continues to be higher than the market expects, then we should continue to see more rate hikes,” he said. “It’s all very uncertain for the bank, for the market, for analysts. These are unprecedented times and the central bank showed it today.”

— With assistance by George Lei, and Sebastian Boyd