Mexican Problems in Inflation Targeting Framework

Mexican Problems in Inflation Targeting Framework
Date: February 6th, 2008
Originally posted in Spanish on: http://economiaregional.weblog.net/

Since Bank of Mexico established its inflation target in 3% during 2004, the central bank has had difficulties to achieve it consistently. In fact, the last inflation report, released in January 2008, indicates two important facts in prices dynamics during 2007: First, the inflation measured through the INPC, doesn’t fluctuate around the goal; and second, the core inflation climbed to 4%, a clear signal that inflation will not converge to the objective in the near future.

I think that the most important implication of this circumstance is that the central bank has not room to use monetary policy during lethargic economic periods, given its own constraints, because the bank fixed its inflation target below of a plausible level of inflation. Under the current situation, even though it’s expected that economic growth tracked below its potential during 2008, it expected that Bank of Mexico doesn’t establish expansive monetary policies as FED did, not only because of low elasticity of active interest rates respect to benchmark interest rates, but because it might erode the credibility of the central bank and create additional inflationary pressures.

However, despite of fact that the inflation has had resistance to low toward more “conformable” level, I think that there is a set of institutional measures to improve the nominal and structural factors that could be affecting the convergence of inflation to its target. I identified four factors of resistance and measures to limit their impact on inflation, as follow:

Non-Competitive Market Structure. If companies in Mexico have no incentives to bargain wages considering the inflation target because its ability to transfer wage increases to prices, then is required to improve the institutional framework to foment competition and avoid abuse of market position, namely those forms that threaten the purpose of the Federal Competition Law, established in its second article: "[P]rotect the process of competition and free competition, through prevention and elimination of monopolies, monopolistic practices and other constraints to the efficient functioning of markets for goods and services". These circumstances can be avoided if the lawmakers give more prerogatives to the Federal Competition Commission in improve the competition framework.

Contract Revisions are not linking with inflation target. The contractual revisions not converge with the inflation target. According to the Ministry of Labour and Social Welfare (STyPS), the reviews of wage contracts in Mexico had increased 5.4%, 4.6%, 4.6%, 4.4% and 4.7% per year during the period of 2003-2007; circumstances which mean higher inflationary pressures on prices setting by private organizations, particular whose that move to the final prices their increases in wages. In this sense is required to promote a proper understanding of the economic phenomena of society, through educational measures to improve economic literacy, such as media campaigns, public discussion forums and speeches; reinforce by the measure in the law of competition.

Credibility problems in INPC calculation. Assuming that the central bank has a strong commitment to achieving the inflation target of 3%, and that economic agents believe it, and assuming that supply shocks are temporary and do not contaminate the expectations of economic agents, and no gains in productivity; we might expect that inflation rates fluctuate around the inflation target, but this situation that has not happened consistently. In this context, an important source of inflationary rigidity could be associated with the incompatibility between inflation published and inflation perceived: lack of credibility in the estimation of INPC. It will eventually improve once it calculates INEGI and it will be enhanced credibility by its autonomy and a wider dissemination of meaning and methodology employed to calculate the indicator.

Central Bank does not exhaust the possibilities of communication with the public. Periodic release of announcements in monetary policy and monetary policy periodic reports by the central bank, can be reinforced with the publication of minutes and more frequent use of public forums by members of Bank of Mexico, in topics related to monetary policy, particularly on issues as the clarification of the cost-benefit of maintaining high reserves or mechanic adjustment of prices caused by temporary disruptions in supply. This measure not only improve the ability to achieve stable inflation rates, but as mentioned Bernanke, "the communication of a central bank in a democratic society is an important requirement for maintaining the democratic legitimacy and independence which are essential for maintaining a sound implementation monetary policy".

A set of measures of this nature will help to observe a statistical property in the index of inflation in Mexico: temporal variations of INPC around the inflation target, and thus benefits for the economy as a further reduction in component premium Inflation in interest rates and greater flexibility in monetary policy, besides the positive effects of the measures, such as enhancing competition within the country.

However, from the perspective of economic science, another question arises in terms of monetary policy given the problems faced by the central bank of Mexico during the last years: Is really an inflation targeting framework a scheme to employ in any economic circumstances? Or this scheme imposes some rigidness to monetary policy in determinate circumstances, particularly with structural and economic constraints such as I cited here.

Salvador Rodríguez Omar Hernández
salva.rguez@gmail.com