Middle East concerns and sluggish economy dominated Banxico rate meeting, minutes show

* Minutes show Banxico board's diverging inflation outlooks

* Some governors see inflation risks from Middle East conflict as limited

* Dissenters urged caution, citing need to assess inflation shocks before further easing (Adds details in paragraphs 1-5, dissenting opinions in paragraphs 11-12)

By Brendan O'Boyle and Emily Green

MEXICO CITY, May 21 (Reuters) - Uncertainty around the impacts of the U.S. and Israeli war on Iran and a sluggish economy weighed heavily on the Bank of Mexico's decision earlier this month to cut the country's interest rate, according to minutes from the meeting published on Thursday.

The central bank, known as Banxico, voted 3-2 on May 7 to lower its benchmark interest rate by 25 basis points to 6.50% and announced an end to its easing cycle that began in early 2024.

The unusually divided decision reflected the bank's diverging opinions about inflation trends in Latin America's second-largest economy.

Bank of Mexico Governor Victoria Rodriguez, along with ?Deputy Governors Omar Mejia and Gabriel Cuadra, voted in favor of the 25-basis-point cut. Deputy Governors Jonathan Heath and Galia Borja voted to keep the rate ?unchanged.

According to the minutes, all five board members highlighted the upward risks to inflation related to the Middle East conflict.

But most - not all - "argued that their direct impact on inflation in Mexico has been limited, partly due to the federal government's fuel price policies," according to the minutes. Mexico stabilizes fuel prices by continually adjusting a federal tax that aims to cushion price swings at the pump.

In fact, the U.S. war with Iran could also cause inflation to fall in Mexico, some of the bank's governors said, given the possibility of weaker global economic activity stemming from the conflict.

Mexico's weak economy was also top of mind for the board members, as most said the economy's 0.8% contraction in the first quarter was "notably greater than anticipated." Year-over-year growth, meanwhile, was nearly flat, despite President Claudia Sheinbaum's efforts to boost investment and domestic production.

The majority of board members emphasized that slack conditions in the economy - meaning many workers and businesses are operating below full capacity - are expected to reduce inflationary pressures.

The central bank's 3-2 rate decision on May 7 followed data showing Mexico's headline inflation cooled slightly to 4.45% in April, though it remains well above Banxico's 3% target. The board does not expect to reach its target until the second quarter of 2027.

Mexico's statistics agency will publish inflation data on Friday for the first half of May. According to a Reuters poll, annual headline inflation is expected to have eased further, reaching an estimated 4.13%, although the core rate is seen ticking up to 4.26% - both forecasts well above Banxico's target.

In voting against the rate cut, Heath and Borja said the bank needs more time to evaluate the impact of recent shocks on inflation.

"Adopting a more cautious approach" would allow the bank to "fulfill its primary mandate of ensuring the Mexican currency's purchasing power and, thus, contribute to our country's growth and development," Borja argued. (Reporting by Brendan O'Boyle; Editing by Emily Green and Aurora Ellis)