BANCO DE MEXICO Mexico’s Underlying Inflation. IntroductionIntroduction Methodology for...

BANCO DE MEXICOBANCO DE MEXICO

Mexico’sUnderlying Inflation

• IntroductionIntroduction

• Methodology for calculating Underlying Inflation in México

• The Mexican Experience with Underlying Inflation

• Concluding Remarks

ContentsContents

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• 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:• Fluctuations in agricultural products;

• Variations in terms of trade;

• Changes in indirect taxes.

IntroductionIntroduction

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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.


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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:

– Prices which have severe volatility;– Prices that are controlled by government (Not determined

under market conditions);– Prices with high seasonality.


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IntroductionIntroductionUnderlying Inflation Indicators in Selected Countries

Central BankUnderlying Inflation(CPI excluding:)RPIX (interest payments on housing loans)

RPIY (the above plus indirect and local taxes)RPIXFE (interest on housing loans plus food, fueland electricity)

TPI (direct taxes)

Bank of England

THARP (indirect and local taxes)

Bank of Spain IPSEBENE (energy and non-processed food)

CPIX (the eight most volatile elements in history)Bank of New Zeland

CPIxFET (food, energy and indirect taxes)

DeutscheBundesbank

Net CPI (indirect taxes)

Bank of France ULI (food, energy, tobacco and indirect taxes)

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• Introduction

• Methodology for calculating Underlying Methodology for calculating Underlying Inflation in MexicoInflation in Mexico



ContentsContents

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Methodology for Calculating Underlying Methodology for Calculating Underlying

Inflation in MexicoInflation in Mexico

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:

Central BankUnderlying Inflation(CPI excluding:)Sub index of Agricultural Products

Sub index of EducationMéxicoSub index of Prices of Goods and ServicesRegulated and Provided by the Public Sector

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Mexico’s Underlying Inflation Index

There is a trade-off when choosing the correct index between:

• Technical accurancy

and

• Simplicity– Time invariable

– Timely release

The process to define the mexican UII involved five steps.

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Identification of the most volatile elements of the CPI.– Deviations between the monthly growth in the price of each generic product and a

measure of the monthly inflation trend (12th month centered moving average) were calculated.

– An indicator of volatility (mean square error) was calculated for each generic product.

Clasification of the most volatile elements

The 313 generic products included in the CPI were listed according to their volatility.



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Inflation in MexicoInflation in Mexico Construction of indices

– Different indices for the UII were defined as possible candidates.

– Each index included all components of the CPI except the subset of the most volatile generic products.

– This allowed to generate a set of indices which differed only in the percentage of the consumer basket that was eliminated.

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.

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Inflation in MexicoInflation in Mexico Technical Accurancy vs. SimplicityThe 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.

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Inflation in MexicoInflation in MexicoMean Square Error with respect to Future Inflation Trend

0.20

0.25

0.30

0.35

0.40

0.45

0% 10% 20% 30% 35% 40% 44% 50%

Percentage eliminated (X)

Moving Average

12-month centered moving average

•Most efficient UII candidate: •Excludes the 35% most volatile elements of CPI.

•Simplifying Aproximation excluding Agricultural, Educational and Administered goods :

•Excludes 32.75% of CPI basket of which 24.23 corresponds to the subset of the 35% most volatile.

Most efficientcandidate35% off

Simplifyingaprox.:24.23% off

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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.

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• Introduction

• Methodology for calculating Underlying Inflation in Mexico

• The Mexican Experience with Underlying The Mexican Experience with Underlying InflationInflation


ContentsContents

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• Banco de México sets its inflation targets using as reference the Consumer Price Index (CPI)

• The Underlying Inflation is used as a communication instrument to support and explain the monetary policy stance of the Central Bank.

Experience with Underlying Inflation

Introduction and familiarization with the Underlying Inflation.

Events that have contributed to the acceptance of this measure

The Mexican Experience with Underlying The Mexican Experience with Underlying InflationInflation

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Introductory Process

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.

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Consumer Prices Index and Underlying Inflation IndexAnnual percentage variation

5

7

9

11

13

15

17

19

21

Au

g-9

9

Oct

-99

De

c-9

Fe

b-0

0

Ap

r-00

Jun

-00

Au

g-0

0

Oct

-00

De

c-00

Fe

b-0

1

Ap

r-01

Underlying

CPI


Events...

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Consumer Prices Index and Underlying Inflation IndexAnnual percentage variation

5

7

9

11

13

15

17

19

21

Au

g-9

9

Oct

-99

De

c-9

Fe

b-0

0

Ap

r-00

Jun

-00

Au

g-0

0

Oct

-00

De

c-00

Fe

b-0

1

Ap

r-01

Underlying

CPI

CPI and Inflation Expectations Annual percentage variation

6

8

10

12

14

16

18

20

Ju

l-9

9

Sep

-99

No

v-9

9

En

e-0

0

Ma

r-0

0

Ma

y-0

0

Ju

l-0

0

Sep

-00

No

v-0

0

En

e-0

1

Ma

r-0

1

0

2

4

6

8

10

12

14

16CPI

Expectation for next 12 months


Events...

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Consumer Prices Index and Underlying Inflation IndexMonthly percentage variation

-0.3

0.2

0.7

1.2

Jan

-01

Fe

b-0

1

Ma

r-01

Ap

r-01

Underlying CPI

Reaction of market analyists:

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.

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• Introduction

• Methodology for calculating Underlying Inflation in Mexico


• Concluding RemarksConcluding Remarks

ContentsContents

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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.

Concluding RemarksConcluding Remarks

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