By Michael O'Boyle and Alexandra Alper
MEXICO CITY, Oct 25 (Reuters) - Mexico's central bank lowered interest rates on Friday for the second month in a row to counter an economic downturn, but policymakers said there were signs the worst of the slowdown had passed and that no further rate cuts were advisable.
The Banco de Mexico lowered its benchmark interest rate by 25 basis points to 3.50 percent, its lowest-ever level. Most analysts polled last week by Reuters had forecast a quarter point cut, though some expected a bigger move.
Mexico's peso rallied as investors trimmed bets of further interest rate cuts in coming months.
Latin America's No. 2 economy slowed sharply this year and shrank in the second quarter, that 'adverse shocks' to the economy in the past few months appeared to be fading.
'Some data suggests that the economy has begun to show an incipient recovery in the third quarter,' the bank said. 'Still, there is a considerable degree of slack in the labor market and the economy as a whole.'
Policymakers added that the inflation outlook had improved and that a government tax reform plan was unlikely to spur widespread price pressures.
'The board ... considers that additional cuts to the reference interest rate target would not be advisable in the foreseeable future,' the central bank said in a statement.
After the statement was issued, Mexico's peso strengthened 1 percent against the dollar before trimming gains to 12.89 pesos, nearly 0.7 percent higher on the day. Yields on short-term interest rate swaps jumped higher as investors scaled back bets of further interest rate cuts in the coming months.
Lower interest rates spur credit expansion and consumer demand, thus fostering economic growth.
Mexico's economy contracted in the second quarter for the first time in four years, prompting policymakers to unexpectedly cut their benchmark rate in September. Devastating floods across the country last month have further dampened growth prospects.
Policymakers said that downside risks to the economy are still high. 'There is another message that they are sending ... the level of the rate will remain at 3.50 for a long time,' said Benito Berber, an analyst at Nomura in New York.
A separate report, issued earlier on Friday by the national statistics institute, showed Mexican factory exports fell in September in a sign of slack U.S. demand while the pace of consumer imports picked up.
While much of Latin America exports commodities, Mexico exports mostly manufactured goods, such as cars and televisions, and it sends nearly 80 percent of its exports to the United States.
A Reuters poll last week showed analysts cut their economic growth outlook for Mexico to 1.3 percent this year, down sharply from 3.8 percent in 2012 and less than half a 2.9 percent rate forecast in July.
Data on Thursday showed Mexico's annual inflation rate eased in the first half of October to 3.27 percent, its slowest pace since January.
The central bank said in its statement that recent flooding, which spoiled crops, was not causing any significant impact to inflation and it added that the impact on consumer prices from higher taxes planned for next year would be transitory.
In its statement on Friday, the central bank said it did not expect economic growth to reach the pace at which it would add to price pressures this year or in 2014. Mexico's central bank targets a 3 percent inflation rate with 4 percent the upper limit of acceptable price gains.
(Editing by W Simon) Keywords: MEXICO ECONOMY/RATES
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