Cost-Push Shocks, Inflation Persistence and Monetary Policy in the Mexican Economy

This paper analyses the response of monetary policy to cost-push shocks using a small- scale macroeconomic model estimated for the Mexican Economy. The purpose is to show that a risk management approach to conduct monetary policy is particularly relevant in the case of small open economies that are in transit from a high to a low inflation equilibrium. In these cases, uncertainty regarding the persistence of inflation presents an important challenge for monetary authorities. Thus, a systematic method to deal with uncertainty is useful to asses the appropriate response of monetary policy to inflationary pressures. Over the last years, the Mexican economy has been converging towards a low inflation equilibrium. The reduction of inflation that has resulted from sound macroeconomic policies in combination with a flexible exchange rate has induced some important changes in the structure of the economy. For example, a reduction in the pass-through effect from the exchange rate to inflation and to inflation expectations, changes in the level and volatility of some macroeconomic aggregates and a reduction in the persistence of inflation. Nevertheless, price stability has not been achieved yet and the long-run inflation target defined by the Central Bank has not been fully incorporated in long-term inflation expectations. Under these circumstances, the cost-push shocks that hit the economy throughout 2004 represented a challenge for monetary authorities. The risk was that the first round effects of these shocks on prices, that should only have a transitory effect on inflation, could lead to second round effects on prices that would compromise the strategy to achieve the long-run target. A key element to define the appropriate response of monetary policy to cost-push shocks is the persistence of inflation. This characteristic of the inflation process depends on the structure of the economy (i.e. exchange rate pass-through, pricing power of firms, credibility on macroeconomic policies, etc.). For example, as the economy consolidates the low inflation equilibrium and credibility on the long-run inflation target is enhanced, firms tend to rely more on their expected costs than on the performance of past inflation to set their prices. The result of firms becoming more forward-looking is that the persistence of inflation decreases and the risk of second round effects on prices after a cost-push shock decreases as well.download