(Adds details on peso, inflation)
By Michael O‘Boyle and Alexandra Alper
MEXICO CITY, Oct 31 (Reuters) - Mexico’s central bank kept interest rates on hold on Friday and argued that a recent spike in inflation would quickly fade next year while flagging the risk that social unrest in the country could dampen a modest recovery.
The Banco de Mexico maintained its benchmark interest rate at a record low of 3 percent, as expected by 15 of 16 analysts polled by Reuters.
Policymakers said the growth outlook was the same as in their last meeting in September when they noted that economic activity had improved. Mexico is expected by economists to grow around 2.5 percent in 2014 after a weak start to the year.
Among the risks that could lower consumer price pressures, the central bank noted, “the possibility of less dynamic economic activity than forecast in case recent social events in the country affect the expectations of economic agents.”
Protesters have taken to the streets in the past month since 43 students were abducted by police in southwest Mexico on Sept. 26. The search for the missing students has derailed President Enrique Pena Nieto’s efforts to focus on economic reforms.
Annual inflation in Mexico accelerated to a nine-month high of 4.32 percent in early October, above the bank’s 4 percent ceiling, but policymakers said on Friday they expect inflation to ease back toward their 3 percent target by mid-next year.
Mexico’s peso slumped to a 2-1/2 year low in mid-October and has recovered slightly since then.
In its statement on Friday, the bank’s board said it could not rule out the possibility of greater Mexican market volatility in the future.
Deeper peso losses could fan inflation through higher import prices.
Emerging market assets around the world have suffered as investors speculate that higher U.S. interest rates will reverse a tide of investment that flowed into developing countries in recent years, searching for higher yields.
Mexico’s central bank is not expected to raise interest rates until the U.S. Federal Reserve lifts borrowing costs, which is forecast for the second half of next year.
Policymakers held their benchmark rate steady at July and September meetings after catching markets off guard with a 50 basis points cut in June to counter sluggish growth.
Recent data showed the service sector contracted in August while exports and consumer imports sank in September.
Yields on Mexican interest rate swaps rose after the decision, and Siobhan Morgan, a debt analyst at Jefferies & Co., said the move higher was likely due to investors abandoning bets on another interest rate cut.
Mexico’s interest rate swap market is betting on a 25 basis point hike by the middle of next year and at least half a percentage point by the end of 2015. (Editing by W Simon)