By Juan Montes 

MEXICO CITY -- The Bank of Mexico raised interest rates by a quarter percentage point Thursday as expected, as the recent appreciation of the peso and inflation that appears to be under control gave the central bank room to soften its tightening stance.

The decision followed four consecutive half-percentage-point rate increases, and brought the overnight interest rate target to 6.5%, its highest level since early 2009.

Since September, the bank has embarked on an aggressive tightening cycle to support the peso and contain inflation expectations at a time of tensions amid protectionist rhetoric from U.S. President Donald Trump.

The peso strengthened against the dollar following the announcement, before giving back some gains and trading in Mexico City at 18.6910, little changed from Wednesday. Some analysts had said in recent days the bank could leave rates unchanged given the recent rally in the currency.

The Bank of Mexico said the likelihood of "some of the most extreme risks" to Mexico's growth materializing appears to be diminishing -- a seeming reference to recent positive expectations for the renegotiation of the North American Free Trade Agreement.

The optimistic tone was accompanied by the bank saying the growth outlook has improved, while the inflation outlook is unchanged.

Yet the central bank -- which has doubled the overnight rate in the past year -- said it remains ready to act boldly if inflation expectations get out of control.

"Despite the significant appreciation of the national currency against the dollar since our last meeting [in early February], uncertainty prevails in the external backdrop," the bank said.

The peso has appreciated around 17% in the last two months, returning to levels not seen since early November.

The Bank of Mexico also said it took into account the rate increase by the Federal Reserve earlier in March and would continue to monitor relative rates between Mexico and the U.S., an indication it could raise rates again if the Fed does.

Annual inflation in Mexico jumped to 5.29% in the first half of March, as the economy still digested an unprecedented rise in gasoline prices at the beginning of the year, but consumer price increases have moderated in recent weeks.

The bank said it expects annual inflation to be above 4% during 2017, to start decreasing in the last months of the year and approach the bank's 3% target by the end of 2018.

Higher local interest rates have supported the peso rally, along with increasing investor confidence the U.S. and Mexico can agree on a renegotiation of Nafta that benefits both countries.

A draft of the proposed changes to Nafta sought by Mr. Trump's government, reviewed by The Wall Street Journal, shows the U.S. administration would seek mostly modest changes in trade negotiations with Mexico and Canada.

A more dovish Bank of Mexico would support Mexico's economic growth, which expanded more than expected in January and showed resilience against a difficult backdrop. Still, growth is expected to slow this year to about 1.8% from 2.3% in 2016 as uncertainty over Mr. Trump's trade policies remains high.

The central bank said the outlook for growth has improved marginally, as the external demand for Mexican manufacturing exports benefited in recent months from a weak peso. The peso hit a record low against the U.S. dollar in mid-January.

Write to Juan Montes at juan.montes@wsj.com

(END) Dow Jones Newswires

March 30, 2017 17:37 ET (21:37 GMT)

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