Central bank building in Mexico, maze of inflation

Mexico's Inflation Puzzle: Is the Central Bank's Cure Worse Than the Disease?

Jordan Keane in Business & Economy August 2025 • 3 min read.

"Uncover the surprising truths behind Mexico's fight against inflation and how traditional economic strategies might be missing the mark."

For years, central banks around the world have leaned heavily on a single tool to combat inflation: interest rates. The playbook seems straightforward: raise interest rates, cool down demand, and watch inflation retreat. But what happens when this cure feels worse than the disease? In Mexico, that's precisely the question economists are starting to ask.

Mexico adopted inflation targeting in 2002, and since then, inflation has generally decreased. The country’s economic authorities have largely credited this success to their strategy, asserting that it has not only curbed inflation but also reduced the impact of exchange rate fluctuations on domestic prices. However, a deeper look reveals some unsettling paradoxes.

A recent study challenges these conventional beliefs, suggesting that Mexico's approach to inflation might be overlooking key factors and potentially causing unintended harm. Are high interest rates truly the answer, or are they masking deeper issues within Mexico's economic structure? Let's explore the evidence.

Interest Rates: The Unexpected Twist

Central bank building in Mexico, maze of inflation

Economic theory suggests that hiking up interest rates should put a damper on spending and investment. Higher rates make borrowing more expensive, which in turn should cool down economic activity and ease inflationary pressures. But in Mexico, the evidence doesn't quite line up with this textbook scenario.

A macro-econometric model estimated for Mexico reveals a surprising twist: higher interest rates appear to be associated with higher GDP. This counter-intuitive finding challenges the very foundation of the central bank's strategy. Why might this be happening?

Exchange Rate Effects: Higher interest rates can lead to a stronger peso. A stronger peso makes imports cheaper, potentially stimulating demand through different channels.
Wage Share Impact: A lower exchange rate can boost the wage share, encouraging consumption.
Debt Relief for Firms: Companies with dollar-denominated debt may experience relief as a stronger peso reduces their debt burden.

These factors suggest that, in Mexico's unique economic landscape, higher interest rates might not be having the intended effect of curbing demand. Instead, they could be creating a complex web of consequences that ultimately fuel economic activity – and potentially inflation – through unforeseen pathways.

A New Perspective on Mexico's Inflation

Mexico's battle against inflation is far from over, and it demands a more nuanced approach than simply tweaking interest rates. By acknowledging the complexities of its economic structure and considering alternative strategies, Mexico can pave the way for a more sustainable and equitable path to price stability.

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Everything You Need To Know

What is inflation targeting, and when did Mexico adopt this strategy?

Inflation targeting is a monetary policy strategy where a central bank announces a specific inflation rate as a goal and uses monetary policy tools to achieve that rate. Mexico adopted inflation targeting in 2002. The idea is to manage expectations and maintain price stability. However, its effectiveness can be debated when factors beyond interest rates significantly influence inflation. Understanding the limitations of inflation targeting is crucial for developing effective monetary policies. Factors like global supply chain disruptions or fiscal policy changes can have a significant impact and require a more comprehensive approach.

How do interest rates typically affect inflation, and what's the surprising twist in Mexico's case?

Typically, raising interest rates is supposed to decrease inflation by making borrowing more expensive, which reduces spending and investment. However, in Mexico, a macro-econometric model suggests that higher interest rates are associated with *higher* GDP. This is unexpected because it contradicts the standard belief that higher rates cool down economic activity. This might be happening because a stronger peso, resulting from higher interest rates, can make imports cheaper and provide debt relief for firms with dollar-denominated debt, stimulating economic activity through different channels.

What are the exchange rate effects in Mexico, and how do they challenge the conventional approach to inflation?

In Mexico, higher interest rates can lead to a stronger peso. A stronger peso makes imports cheaper, potentially stimulating demand and economic activity. Furthermore, a lower exchange rate can boost the wage share, encouraging consumption. These effects suggest that higher interest rates might not be curbing demand as intended; instead, they may be fueling economic activity through unforeseen pathways. This challenges the conventional approach to inflation, which assumes higher interest rates will automatically dampen demand and lower inflation.

Besides interest rates, what other factors should Mexico consider in its battle against inflation?

Mexico needs a more nuanced approach that acknowledges the complexities of its economic structure. This includes considering the impact of exchange rates on imports, wage share, and debt relief for firms. Simply tweaking interest rates might not be sufficient, and Mexico should explore alternative strategies for achieving price stability. These could involve fiscal policies, supply-side reforms, or measures to address structural issues within the economy. It's crucial to look beyond traditional monetary policy and understand how different sectors and policies interact.

What are the potential implications of Mexico's unconventional response to interest rate hikes on firms with dollar-denominated debt?

The strengthening of the peso resulting from higher interest rates offers considerable debt relief for firms in Mexico that have dollar-denominated debt. When the peso strengthens against the dollar, the amount of pesos needed to pay off dollar debts decreases. This situation improves firms' financial positions, potentially freeing up capital for investment and expansion. However, it also creates a complex scenario where the intended effects of interest rate hikes (to curb inflation by decreasing spending) are offset by the unintended consequence of stimulating economic activity due to improved corporate finances.