Mexico's inflation rate jumped to 4.63 percent in early January, above the Bank of Mexico's 3.0 percent target, due to higher public transport prices and taxes, and the central bank expects inflation to remain above 4.0 percent during the first few months of this year before it declines in the second quarter and remains within the bank's acceptable range of between 2 percent and 4 percent.
But the Bank of Mexico, which cut its target for overnight rates three times in 2013 by a total of 100 basis points, said it can't rule out that this temporary spike can lead to higher inflationary expectations, affecting the general price level, nor that the peso's exchange rate will be hit by volatility in global financial markets as they adjust to the reduction in asset purchases by the U.S. Federal Reserve.
"The Board (of the central bank) will remain vigilant to all pressures that might affect medium and long-term inflation and expectations," the central bank said, and it is monitoring the implications of inflation forecasts on economic activity and the relative monetary stance of Mexico to the United States in order to achieve the bank's inflation target.
Mexico's inflation rate started to pick up in November from a year-low of 3.36 percent in October, rising to 3.62 percent and then 3.97 percent in December, pushed up by higher transport prices and a seasonal rise in agriculture prices.
The further rise in early January has mainly affected goods and services directly impacted by higher taxes on soft drinks, junk food and carbon-based fuel and not lead to any rise in other prices, the central bank said. Inflation expectations for 2014 have picked up due to the expected impact of taxes, but remained stable for 2015, it added.
"This keeps the forecast in the sense that the recent increase in inflation will be temporary and will not affect the formation of prices in the economy," the central bank said.
The central bank has on several occasions in recent months said inflation this year should rise temporarily due to these higher taxes but expectations are still stable for 2015. In 2015 the government will start linking fuel prices to inflation, instead of monthly increases, removing a major contributor to inflation.
But the balance of risks to the central bank's inflation forecast has deteriorated due to the major adjustment in capital flows to emerging markets, and thus the cost of funds for Mexico, from the process of normalizing U.S. monetary policy, the bank said.
So far, Mexico's peso currency has fared better than many other emerging market currencies, down by only 2.6 percent this year to the U.S. dollar this year, trading at 13.39 to the dollar today. Last year the peso also weathered the drop in emerging market currencies much better than other currencies, falling by only 1.5 percent during the year, although it's largest decline came during May.
Overall, the central bank said the outlook for global economic growth has improved, though emerging markets could face higher costs of external finance, which it said highlights the importance for them to maintain fiscal discipline.
International commodity prices have continued to moderate in recent months and international inflation remains low.
Mexico's economy is also continuing to recover and is expected to continue to improve, the bank said, due to improved external demand and a nascent recovery in some parts of domestic demand, such as private consumption and government spending. Investment, however, has not yet shown sign of improving.
But better prospects for the U.S. economy could mean better demand for Mexico' products and structural reform measures could lead to better investment prospects in the medium term so the rate of economic growth can accelerate without generating inflation.
Mexico's economy slowed sharply last year compared with the two previous years and in the third quarter of 2013 its Gross Domestic Product only expanded by a quarterly 0.84 percent after a contraction of 0.55 percent in the second quarter. Compared with the third quarter of 2012, third quarter GDP grew by 1.3 percent, down from 1.6 percent in the second quarter.