BANCO DE MEXICO. Mexico’s Underlying Inflation. Contents. Introduction Methodology for calculating Underlying Inflation in México The Mexican Experience with Underlying Inflation Concluding Remarks. 2. Introduction. About Inflation Indicators
Central objective: To obtain an indicator of inflation closer to its theoretical definition.
The Consumer Price Index (CPI) is used in practice as the indicator of inflation.
Problems associated with CPI use:
a) CPI is only a subset of general level of prices;
b) CPI is prone to reflect changes in relative prices due to:
Consequently, those modifications in CPI which correspond only to variations in relative prices may induce a mistaken interpretation of the inflationary process. Such an error might mislead the design of monetary policy and hence impose severe costs over the real sector of the economy.
Alternative measures of inflation
The objective of constructing alternative measures of inflation is to obtain better indicators of the theoretical inflation. Thus, it will be possible to correctly identify and take actions to control the “true” inflation.
Transitory changes in consumer prices caused by seasonal effects, does not reflect underlying inflationary pressures.
Many central banks have developed alternative inflation measures that reflect the trend of the growth of prices. Such measures exclude:
México also calculates a measure of underlying inflation. The Underlying Inflation Index (UII) is a subset of the CPI that excludes the items included in the following subindices:
Mexico’s Underlying Inflation Index
There is a trade-off when choosing the correct index between:
The process to define the mexican UII involved five steps.
Identification of the most volatile elements of the CPI.
Clasification of the most volatile elements
The 313 generic products included in the CPI were listed according to their volatility.
Construction of indices
Selection of the most efficient index
To determine which of these indices was the most efficient indicator of trend inflation, each of them was compared against the previously defined CPI trend using the mean square error. The most efficient one was that with the lowest MSE.
Technical Accurancy vs. Simplicity
The best, as defined, UII was achieved by eliminating 35 percent of the most volatile generic products.
Of the 93 generic products comprised in the 35 percent most volatile subset of the CPI basket, 66 belong to one of the following subindices: Prices of Goods and Services controlled or Provided by the Public Sector, Agricultural Products, and Education.
Therefore, an index excluding these subindices behaves almost as efficient as the one which excludes the 35% most volatile components.
Methodology for Calculating Underlying Inflation in Mexico
What does UII does not capture?
Volatility of Agricultural products deep impact on short run movements of the CPI.
Seasonal and ocassional changes in prices of some agricultural products.
Movements in controlled prices.
Experience with Underlying Inflation
Introduction and familiarization with the Underlying Inflation.
Events that have contributed to the acceptance of this measure
Although mentioned for the first time in 1998’s Annual Report of Banco de México, Underlying Index was not fully explained and presented until April 2000 in the first Quarterly Report on Inflation published.
Underlying Inflation was mentioned extensively in the quarterly reports, special bulletins, and speeches of the members of the board of Governors. Thus, private sector analysts became familiarized with this Index.
CPI and Inflation Expectations
Annual percentage variation
Expectation for next 12 months
After all these events, market analysts began to formulate its inflation expectations taking into account the evolution of Underlying Inflation.
However, this has not already impacted wage negotiations or other type of contracts based on inflation expectations.
The Mexican Experience with Underlying Inflation
In Mexico underlying inflation is only a tool for analysis and communication and not a monetary policy target in itself.
Consistency in the reading that the Central Bank does of the UII performance fosters credibility on monetary policy.
As an indicator that reflects medium-term inflationary path, authorities shall induce economic agents to deeply incorporate UII information in the process of formulating expectations.