By Noe Torres, Lizbeth Diaz and Ana Isabel Martinez

MEXICO CITY (Reuters) - Beyond the common challenges like currency fluctuations and supply shocks that keep the world's central bankers up at night, in Mexico there is an additional foe for those conjuring monetary policy: protection rackets.

Extortion has become a massive problem in Mexico, with powerful drug cartels exerting deep influence over swathes of the country. Keen to establish new revenue streams, these groups have been turning to extorting businesses by forcing them to pay protection money.

One unintended consequence: inflation.

Reuters interviewed about 20 small merchants and producers, selling goods such as limes and tortillas, who said they are regularly forced to pay protection money.

Leaders of business associations confirmed the problem and said they estimate extortion adds around 20% to the prices of some items.

The problem is increasingly being noticed by policy wonks and central bank officials even if concrete data on the phenomenon remains scarce.

"We have ample anecdotal information which shows that it (extortion) is not only an important factor but a growing one, which is contributing to the inflationary process we are encountering," deputy central bank governor Jonathan Heath told Reuters in a written response to questions last week.

Like many other countries, Mexico has struggled with high inflation in the wake of the COVID-19 pandemic. Annual inflation was running at 5.16% in the first half of August and has been gradually cooling from a two-decade peak of 8.77% in 2022. But it remains stubbornly far from the 3% targeted by Mexico's central bank, known as Banxico.

Earlier this month, Banxico lowered its benchmark interest rate by 25 basis points to 10.75% in a divided vote, in which Heath voted not to cut. Despite the move, the bank signaled it expected prices to rise higher than it had previously forecast.

Heath said the problem of extortion in the Mexican economy now had to be viewed as "structural," which "makes it difficult to achieve our goals" on inflation.

"The problem is that while we know it affects the Bank's ability to achieve our objective... we have no way of quantifying it nor of adjusting our 3% target to take it into account."

COMPLICATED WORK

Incidents of extortion are thought to be hugely under-reported in Mexico, but the data there is shows a steep increase over the presidency of Andres Manuel Lopez Obrador, who has pursued a less confrontational approach to the drug cartels.

That approach has meant fewer firefights between security forces and the cartels and has been credited by some for reducing the homicide rate - though murders remain high at over 30,000 per year, according to official data.

Registered victims of extortion jumped from 6,895 in 2018, when Lopez Obrador took office, to a record 11,039 in 2022, dipping slightly to 10,946 in 2023.

"The work of Mexico's central bank is more complicated than in other countries that don't have this problem (of extortion)," said Jacobo Rodriguez, analyst at Roga Capital.

Extortion "is generating effects which are impacting inflation and are outside the economic dynamic," he added.

Banxico did not respond to a request for comment on how extortion was impacting prices.

A regional economic report by the bank in 2023 said that company executives across Mexico had stressed that crime against producers, particularly theft and extortion, had resulted in higher costs for companies and higher consumer prices for products such as avocados, limes, cereals, and other food staples. No specific figures were given.

One sector leader, who asked not to be identified, citing security risks, said that extortion had pushed prices of tortillas up 20% in some places.

In just the first half of August the price of limes, meanwhile, rose some 8% as farmers in Michoacan state, Mexico's No.1 producer, stopped work to protest rising extortion, with cartels demanding four pesos (0.20 dollars) per kilo - over half the usual sales price for producers.

"The phenomenon of extortion has reached worrying levels with a significant impact which doesn't just affect the companies that are directly being extorted but has ramifications on consumers' pockets," said Andres Abadia, economist at Pantheon Macroeconomics.

(Reporting by Noe Torres, Lizbeth Diaz, and Ana Isabel Martinez; editing by Stephen Eisenhammer and Rosalba O'Brien)