Mexico's central bank cut its target for the interbank rate by 25 basis points to 3.75 percent, a surprise to financial markets, saying economic growth this year and 2014 will be weaker than expected, putting downward pressure on inflation.
The Bank of Mexico, which also cut its rate in March, said the downside risks to the economy had risen and growth this year will be "considerably" less than forecast, just as growth in 2014 will be below the forecast. In its latest quarterly inflation report released last month, the central bank cut its forecast for 2013 growth to 2.0-3.0 percent from a previous 3-4 percent.
"On balance, there are prevailing risks to global economic growth and in this context, coupled with the absence of significant pressure on commodity prices, the outlook for global inflation is low," the central bank said, describing the global economy as having a mixed performance.
Economic activity in Mexico slowed significantly in the second quarter, mainly due to a contraction of the industrial and services sectors, increasing the slack in the economy, and the central bank expects this to continue for an extended period. In addition, the government is also expected to make further progress in strengthening public finances.
Mexico's Gross Domestic Product contracted by 0.74 percent in the second quarter from the first quarter for annual growth of only 1.5 percent, up from 0.6 percent in the first quarter, but well below growth in the previous three years.
Mexico's inflation rate also fell more than expected to 3.5 percent in the first half of August, with core inflation below 2.5 percent, the bank said. In July, the headline inflation rate eased to 3.47 percent in July from 4.09 percent in June.
While medium and long-term inflation expectations have remained stable, expectations for the end of this year have declined as the impact of recent supply shocks did not have second-round effects.
"With regard to inflation risks in the short term, there is the possibility that the weakening of Mexico's economic activity is greater and more prolonged than expected and that could cause downward pressure," said the bank, known as Banxico.
The central bank said in July that it expected inflation this year to be very close to its target of 3 percent, but said today that the slack in the economy points to lower-than-predicted inflation and even changes from a tax reform would only have a transitory impact and probably no second-round effects.
The central bank noted the recent volatility and pressure on the currencies of emerging economies, including Mexico's, and higher medium and long-term interest rates due to the expected changes in U.S. monetary policy.
"Mexico's sovereign risk, unlike other emerging economies, has remained stable after having increased in May and June, contributing to the strength of Mexico's macroeconomic fundamentals," the central bank said.
Last month the central bank's governor, Agustin Carstens, said in Jackson Hole he thought the bank's monetary policy stance was adequate to reach the inflation goal as the peso was weakening and growth was slowing.
In March the central bank cut its rate by a larger-than-expected 50 basis points but had stressed it was not embarking on a new cycle of easing. It has now cut rates by 75 basis points this year.
Along with other emerging market currencies, Mexico's peso fell in May, but then bounced back in July before slipping in August. It was down almost 4 percent against the U.S. dollar since the start of this year, but rose after the rate cut, trading around 13.2 to the dollar.