BANCO DE MEXICO

1. BANCO DE MEXICO Mexico’s Underlying Inflation

2. Contents • Introduction • Methodology for calculating Underlying Inflation in México • The Mexican Experience with Underlying Inflation • Concluding Remarks 2

3. 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: • Fluctuations in agricultural products; • Variations in terms of trade; • Changes in indirect taxes. 3

4. Introduction 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. 4

5. Introduction 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. 5

6. Introduction 6

7. Contents • Introduction • Methodology for calculating Underlying Inflation in Mexico • The Mexican Experience with Underlying Inflation • Concluding Remarks 7

8. Methodology for Calculating Underlying Inflation 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: 8

9. Methodology for Calculating Underlying Inflation in Mexico 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. 9

10. Methodology for Calculating Underlying Inflation in Mexico 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. 10

11. Methodology for Calculating Underlying Inflation 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. 11

12. Methodology for Calculating Underlying Inflation in Mexico 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. 13

13. Methodology for Calculating Underlying Inflation in Mexico Most efficient candidate 35% off Simplifying aprox.: 24.23% off • 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. 12

14. 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. 14

15. Contents • Introduction • Methodology for calculating Underlying Inflation in Mexico • The Mexican Experience with Underlying Inflation • Concluding Remarks 15

16. The Mexican Experience with Underlying Inflation • 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 16

17. The Mexican Experience with Underlying Inflation  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. 17

18. The Mexican Experience with Underlying Inflation 18

19. The Mexican Experience with Underlying Inflation CPI and Inflation Expectations Annual percentage variation  Events... 16 CPI 20 14 Expectation for next 12 months 18 12 16 10 14 8 12 6 10 4 8 2 6 0 Ene-00 Ene-01 Mar-00 Mar-01 Jul-99 Jul-00 Nov-99 Nov-00 Sep-99 Sep-00 May-00 19

20. The Mexican Experience with Underlying Inflation  Events... 20

21. 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. The Mexican Experience with Underlying Inflation 21

22. Contents • Introduction • Methodology for calculating Underlying Inflation in Mexico • The Mexican Experience with Underlying Inflation • Concluding Remarks 22

23. Concluding Remarks  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. 23