The Reference Interest Rate

Banxico's Objective and the Inflation Target

The Bank of Mexico (Banxico) is the country's central bank. It is the only institution that puts cash (bills and coins) into circulation, and it regulates how much money and credit circulate in the economy. Its main objective, according to the Constitution, is to seek the stability of the purchasing power of the national currency. In simple terms: your pesos should buy about the same tomorrow as today.

When prices rise across the board and keep rising, there is inflation, and purchasing power falls. In Mexico it is measured with the INPC (the National Consumer Price Index, calculated by INEGI).

Very low or negative inflation is not good either. A 3% target leaves a reasonable margin. The ±1 recognizes that Banxico cannot control prices down to the last cent: there are shocks such as droughts, which make tomatoes more expensive, or oil price hikes.

Central Bank Autonomy

Since 1994, Banxico has been autonomous: neither the president nor the federal government gives it orders about how much money to issue or at what rate to operate. Its decisions are made by a Board of Governors.

Why? Imagine that the government needs to pay for public works or programs and does not want to raise taxes or borrow. The temptation is easy: order more money to be printed. But if there are more pesos and the same amount of goods, prices rise. This is what happened in Mexico in the crises of the 1970s and 1980s, and in 1994-1995, with very high inflation that damaged savings and wages.

The Reference Rate and Its Direct Effect

Banxico does not control prices directly. Its main tool is the reference interest rate (target rate): the rate at which banks lend money to each other overnight. This rate becomes the "floor" of the cost of money: banks use it to set what they charge for loans and what they pay on savings.

Example: Banxico raises the rate from 10.50% to 11.25% per year. The increase is $11.25 - 10.50 = 0.75$ percentage points. Lending and borrowing become more expensive; saving becomes more rewarding.

The Transmission Chain

Monetary policy does not act all at once: it follows a chain of reactions that takes months (sometimes more than a year) to reach prices. That is why Banxico makes its decisions looking ahead.

Link by link:

• Credit: credit cards, auto loans, and payroll loans cost more, and businesses postpone investments (a new branch, machinery).

• Savings: earning more interest makes it attractive to keep money in the bank instead of spending it.

• Aggregate demand: if families and businesses buy less, total demand falls.

• Prices: with less demand, sellers have less room to raise prices, and inflation slows down.

A Second Channel: The Exchange Rate

Besides credit, the rate also works through the exchange rate. If Mexico pays higher rates than other countries, investing here (for example, in Cetes) yields a higher return. Foreign investors exchange dollars for pesos to buy those instruments.

More demand for pesos means the peso appreciates against the dollar. For example, if the exchange rate goes from $\$18.00$ to $\$17.20$ per dollar, fewer pesos are needed to buy one dollar.

A stronger peso makes imports cheaper: gasoline, yellow corn, cell phones, and spare parts, everything bought in dollars. This pushes prices down and reinforces the effect of the rate.

Go back to the beginning: when Banxico raises the rate, your family's auto loan becomes more expensive because banks raise what they charge. Banxico does this to cool demand and bring inflation back to the target of 3% ± 1 percentage point.

Summary