The Problems with Inflation Projections by Bank of Mexico

Bank of Mexico increased its 2008 inflation projection due the higher prices expected in commodity prices; the superior interval changed to 6% in the second quarter from 4.75% in the first quarter, published in the quarterly report of inflation. The central bank said in its statement: “The revised forecast reflects, […] the trajectory upward in recent months of food, energy and metal in international markets, which was more pronounced that the anticipated in future markets at the end of the previous quarter”. This announcement affected economic indicators in México: it lead an five days-appreciation of the peso against the dollar to 9.90 from 10.05 pesos per dollar, given the expectation of further monetary tightening; and the survey of inflation expectations by professional economists shown an average expectation of 2008 inflation above 5%, a level never estimated before.

The relevant point is that commodity data employed to forecast inflation come from future markets. The central banks, investors and other organizations take data from futures markets as source in inflation projections. It makes sense because it is expected that in future market participants use efficiently the information from supply and demand side to incorporated in their decisions shaping the future prices. However, during the last months these markets shown a volatile behavior, particularly an unusual uncertainty from the expectations of demand side, causing that the market reacts broadly with new information related to prospects of world growth; in fact, the economic data of sluggish international demand released recently, has dropped commodity prices in the last four weeks; principally oil (18%), corn (26%), and wheat (5%).

¿What are the implications for monetary policy make decisions with information from future markets that has under-predicted prices?, ¿What are the consequences of release projections in a inflation targeting framework? I think that the central bank needs to make an assessment of the implications of employ information with high volatility like the data from futures markets to release inflation projections; principally by two reasons: First, because the information is public, and in a framework of monetary policy with target inflation, the expectations matter, then we could see some influence over inflation expectations from a sources with high volatility like financial markets. Second, the decisions of monetary policy is based largely with projections; therefore, it is quite possible to make policy errors extracted from such kind of information, at least in this kind of environment we’re seeing. If these implications are true, the central bank must persist in improve their methods in forecast inflation and the way how the Bank communicate these projections.