Mexico; How Interest Rates Can Be Used to Manage an Economy
The management of the economy, undertaken with strategies from the government and decision fro the central bank, is usually undertaken with the aim of promoting and supporting a stable economy, balancing the desire for sustainable growth with the need to constrain inflation. This is an issue faced by almost all countries; inflation can be harmful to an economy, impacting not only in the internal stakeholders, but influencing the exchange rate. The control of inflation, often through the use of interest rates, may also help to stifle growth. This can be a conundrum, as stimulating growth and constraining inflation requires a very careful balance of economic policies. Mexico has been faced with this issue and in March 2013 the Banco de Mexico
made a surprise decision to reduce their interest rates from 4.5% to 4% (Trading Economics, 2013), and then hold the rate at 4% in April (Hughes and O'Boyle, 2013). Management of the economy is a tricky balancing act, and when the country had a growth rate substantially above that of many western countries in the post global recession period, one may wonder why there was a reduction in interest rates. Looking at the situation of Mexico and the use of interest rates it is possible to examine the reasons for the decision and how the rate reduction may be good for Mexico's economy in the long-term.
Mexico has performed relativity well over the last few years; the economy has been showing positive growth well above rates in the more developed countries. In 2012 it was estimated that the real rate of growth in the GDP was 4%, in 2011 it was 3.9% and in 2010 it was 5.6% (CIA, 2013). Three years of growth has been beneficial to the country. With an official GDP of $1.163 trillion in 2012, which equated to a per capita rate of $15,300 in purchasing parity terms (CIA, 2013), it is also apparent there is likely to be more room for growth in the economy.
The results would appear to indicate that there is not an issue with growth in the economy. The strength of the economy explains why the interest rates in Mexico have been higher than nations such as the U.S., the UK and Japan. For example, the Federal Reserve in the U.S. set a rate of 0.25% in December of 2008 which remains in place to the current day (Trading Economics, 2013). The UK had had an interest rate of 0.5% since March 2009 and Japan has an interest rate of 0% (Trading Economics, 2013). The difference in the performance of the Mexican economy and these three developed nations can be seen in their respective GDP growth rates. While Mexico saw their GDP grow by 4% in 2012, in the U.S. there was only growth of 1.9% for the year, with some quarters being particularly low; for example the third quarter of 2012 only saw growth of 0.4% compared to the same period in the previous year. The story was similar in the UK, with the real growth for the year 2012 estimated at -0.1% (Index Mundi, 2013), and in Japan the GDP real growth rate it was 2.2%, with the previous year having real growth rate of -0.8% (Index Mundi, 2013). In all three cases the lower interest rates are present where there is a desire to stimulate growth in the economy. It is notable that in all of these economies inflation rates have also remained low.
The main idea is that lowering interest rates will stimulate the economy as a result of the increase the level of disposable income that is available. When interest rates are low households and companies with debt will spend less on servicing that debt. With less money spent to service debt, the level of disposable income that can be spent on other items or services increases. If people and companies have more money they have two main options to spend it or save it. When interest rates are low there are limited benefits associated with saving, as the return on money is low. Additionally, when interest rates are low and the cost of debt is low, further stimulation is created by facilitating lending; companies and individuals are more likely to borrow money when it costs them less, which will increase their utility. The borrowing of money by households or companies will therefore help to stimulate demand further, as well as aiding the credit creation cycle.
In March 2013 Mexico lowered their interest rate to 4%, from the previous level of 4.5% (Hughes and O'Boyle, 2013). This lowering of the interest rate was the first reduction in four years (Hughes and O'Boyle, 2013). The decision was a surprise to the markets, a surprise which can be explained when considering the relatively healthy level of growth seen in the Mexican economy. Understanding the reason for the higher interest rate can be partly supported by looking at the rate of growth in real GDP. However, unlike the U.S., the UK in Japan, Mexico has also been dealing with a problem of inflation. While it is generally recognized that for economic growth to take place there needs to be a moderate level of inflation in any economy, where it is too great it can have negative effects (Howells and Bain, 2007). It is generally believed that a rate of between 1.5% and 2.5% is sufficient to provide for sustainable growth without the negative impacts (Nellis and Parker, 2000). In Mexico the inflation rate has been much higher, as shown in figure 1 below.
Figure 1; Inflation rate in Mexico 2008 -2013
(Trading Economics, 2013)
During the entire period the inflation rate is not drop below 3%. The higher interest rates seen over the last few years can be considered in the context of the inflation. If lowering interest rates to stimulates demand, increasing them, or holding them higher may help to stifle or slow down demand. Inflation occurs when there is too much money chasing too few goods, by reducing the amount of money, or in this case disposable income, the pressures for inflation reduced (Nellis and Parker, 2000). Therefore, in line with Mexico's stated policy, the level of interest rates appear to have been implemented to reduce the rate of inflation, a strategy which according to the graph above appears to have had some limited success, with interest rates being held to avoid stifling growth.
The balance between supporting growth and constraining inflation can be argued as the motivation behind the decision to reduce interest rates in March 2013. Many commentators who had been watching Mexican interest rates had expected the rate to be decreased, but the decrease was forecast for later in the year. It appears that there are two potential factors that have motivated the central bank to decrease the interest rates. In 2012 the inflation rate was 3.1%, the target rate for the central bank was 3%, and therefore the inflationary pressures within the economy were subsiding giving the bank a little bit more flexibility (Thompson, 2013). However, a significant factor has been the noted slow down in several sectors of the economy, particularly manufacturing and textiles (Thompson, 2013). It is known that when monetary policies are used to make adjustments to an economy there will be a lag and that the process is inexact (Nellis and Parker, 2000). If there is a current slow down, and forecasts indicate that slow down will continue, delaying taking action to stimulate the economy may increased the impact on the slow down on the overall economy. Mexico adopted a proactive strategy, reducing the interest rates now to help alleviate a problem that was emerging and protect the economic growth.