By Andres Rodriguez Brauer
The people of England made a momentous decision in the 23rd of June, when they voted in favor to leave the European Union. The most obvious effects have been on the Pound, which has fallen 14% since the vote and is at its lowest value since 1985. However, the effect of their decision has most definitely not been limited to just the United Kingdom and the international community’s worries seem to be warranted. In fact, countries all around the world have already had to react and Mexico’s response stands out amongst all.
First, some context. Back in February, the Mexican Central Bank decided to differ from the Federal Reserve and hiked its interest rates in order to curb peso speculation. Given the Mexican peso’s liquidity, the currency is often utilized as a hedge mechanism against global risks. The nature of the functioning of the foreign exchange markets raised questions about whether the speculation was routine or if it reflected systemic issues with the Mexican economy. The Bank of Mexico, however, argued the former and thus justified its hiking of interest rates to clamp down on inflation resulting from devaluation.
Similar to the British Pound, the Mexican Peso suffered severe devaluation after the Brexit vote. It dropped 7.15% during the aftermath of the Brexit vote, trading at 19.52 pesos per dollar. The Bank of Mexico responded by increasing their benchmark interest rates by 50 points, in yet another bold decision by the central bank to prevent inflation, despite it currently being at only 2.6%. This response is very different from that of the Bank of England, which is considering decreasing their interest rates below the current rate of 0.5%, which is already a record low for the bank. The Bank of England is not worried at all about inflation, given that the UK has inflation at 0.5% as of April 2016 and thus expansionary policy makes a lot of sense at the time, particularly when the negative shock of the Brexit could potentially send them into deflation.
Having said that, it might be unwise for the Bank of Mexico to follow its current path of reining in inflation further. Despite the counteractive effect it has had in relation to the external market conditions following the Brexit vote, their fear of inflation is overstated given the current situation. The devaluation of the peso, stemming from a global speculative capital outflow from emerging markets, likely means only that the international markets are worried about the Brexit’s effect unto developing economies and Mexico due to the worldwide uncertainty. Simply put, the cause of the subsequent devaluation is well founded fear by investors in regards to worldwide effect of the Brexit. The decrease in aggregate demand coming from this uncertainty and fear should be partially counteracted by the devaluation of the peso in its currency market. By increasing interest rates, they are preventing this and are adding yet another negative shock to the country’s aggregate demand. As a result, it is likely that the Mexican economy will now underperform predictions and grow at a rate lower than the 2.6% that was estimated.
This distinct approach to a sudden decrease in aggregate demand worldwide brings us to the divergent responses to the 2007 financial crisis by the Federal Reserve and the European Central Bank. While the United States responded to the recession with aggressive expansionary policy, the European Central Bank sided with inflation hawks and enacted tight monetary policy. As a result, aggregate demand and growth in the Eurozone was low, relative to nations which adopted looser policies and in fact continues to flirt with deflation, causing the slow return of the Eurozone’s real GDP to pre-recession levels. In comparison, the American GDP is now 10.8% higher than it was in 2007.
It is clear that the Brexit shock is nowhere near the same size as the American housing crisis of 2007 and the ensuing global financial crisis. Thus it is unlikely that the Bank of Mexico’s decision will be as painful as that of the European Central Bank. Nonetheless, by siding with the inflation hawks, Mexico will continue to lag behind and will have slower growth than it would have had they acted differently.