Mexican floods likely to deepen central bank concerns on growth

By Michael O'Boyle and Alexandra Alper

MEXICO CITY (Reuters) - Mexico's central bank was divided over its unexpected interest rate cut early this month to counter a slump in growth, but the damage from historic floods hitting the country could strengthen bets for another cut in October.

Board members voted 3-2 to cut their benchmark rate by 25 basis points to 3.75 percent on September 6, the lowest level since the key rate was introduced in early 2008, according to minutes of their discussion released on Friday.

A majority of board members thought growth in Latin America's No. 2 economy could remain weak for a prolonged period, which justified lower borrowing costs, the minutes said.

Since the cut, heavy rains from two major storms have caused massive flooding across Mexico and the damage from the disaster will drag down growth following an economic contraction in the second quarter.

"I think there are clear grounds for another cut in October," said Alonso Cervera, an economist at Credit Suisse in Mexico City, who correctly predicted September's move.

The lack of agreement slightly weakened bets on another cut in October. Yields on Mexican interest rate swaps edged up and they now suggest an about 1-in-4 chance of a 25 basis point cut in October, compared to nearly even odds seen earlier this week.

The two board members who voted against the cut were hesitant to move ahead of a meeting by the U.S. Federal Reserve this week, at which U.S. policymakers were widely expected to begin to dial back their unprecedented stimulus program.

However, the Fed decided to keep its stimulus unchanged and it highlighted concerns about the health of the economy of the United States, Mexico's top trading partner.

Some Mexican policymakers worried that lower local interest rates would significantly undermine the appeal of local assets to yield-hungry investors and add to volatility. One feared a cut could spur big outflows and hurt the peso.

However, Mexico's peso gained after the surprise cut as the market welcomed the bank's commitment to helping the economy through its soft patch.

Analysts noted the majority's arguments for lower interest rates had strengthened since early September due to the economic damage from flooding as well as the Fed's move.

"Against this backdrop, we continue to believe that Banxico will implement an additional 25 basis point rate cut in the next meeting," Barclays' Marco Oviedo wrote in a research note.

Mexico's economy has stumbled this year amid slack U.S. demand for local exports and a drop in domestic construction. Growth is expected to slow to 1.8 percent this year from 3.8 percent in 2012.

Concerns about the withdrawal of Fed stimulus drove big losses in the peso earlier this year. But a majority of policymakers noted the currency losses had not hurt inflation expectations.

The majority also argued that markets had largely priced in the impact of less Fed stimulus, and they were confident that lower local interest rates would not significantly add to the pressures on Mexico from global financial turbulence.

The majority's bold move has so far paid off. The Mexican peso rallied after the cut and it hits its strongest level in a month after the Fed held its stimulus program in place.

September's cut was the second divided rate decision since the bank began publishing minutes 2-1/2 years ago. The previous was March's unexpected rate cut, which was a 4-1 decision.

(Reporting by Michael O'Boyle and Alexandra Alper; Editing by W Simon and Tim Dobbyn)