Forecasting Mexico’s Inflation: the Effects of an Inflation Targeting Regime

This paper studies the effects the implementation of an inflation targeting (IT) regime has on the dynamics of inflation in Mexico. We contextualize the need for a regime change and study whether the implementation of this regime has made a considerable change in the dynamics of inflation in Mexico. Consumer prices are modelled using a markup model. The markup model suggests a long run relationship where the domestic price level is a markup over total unit costs, including unit labor costs, import prices, and energy prices. We then account for short-run dynamics by using an error correction model and address the issues of co-integration, dynamic specification, and parameter constancy. The results presented in this paper show the institution of an IT regime in Mexico had drastic effects on the dynamics of inflation. Namely, a Chow Test for regime change shows the existence of a different model of inflation in Mexico during the IT years. Similarly, we find the variance of the residuals of the forecasting models are significantly different after the regime change and appeal for a completely different model for these years. Results presented here advocate in favor of the notion that the regime change in Mexico had economy-wide proportions and most importantly, that the Bank of Mexico regained its credibility by successfully curbing inflation. ∗I owe gratitude to Dr. John Huston, Dr. Julie DeCourcy, Mike Ashton, Dr. Manuel Francia and Dr. Jorge González for advising me throughout this project. Special thanks to the participants of the 5 annual Carroll Round at Georgetown University, and most particularly to Marina Lafferriere, for their comments and suggestions. Forecasting Mexican Inflation Juan Carlos Suárez Serrato– Page 2