Forecasting inflation in Latin America with core measures

Abstract

We explore the ability of core inflation to predict headline CPI annual inflation for a sample of 8 developing economies in Latin America during the period January 1995-May 2017. Our in-sample and out-of-sample results are roughly consistent in providing evidence of predictability in the great majority of our countries, although, as usual, a slightly stronger evidence of predictability comes from the insample analysis. The bulk of the out-of-sample evidence of predictability concentrates at the short horizons of 1 and 6 months. In contrast, at longer horizons of 12 and 24 months, we only find evidence of predictability for two countries: Chile and Colombia. This is both important and challenging, given that monetary authorities in our sample of developing countries are currently implementing or given steps toward the future implementation of inflation targeting regimes, which are heavily based on long run inflation forecasts.

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“…Additionally, we consider the optimal combination between both forecasts. The optimal weight assigned to each forecast is determined by expression (35), and the combined forecast is constructed as follows:…”

“…Notice that Model 3 is similar to Model 1 but uses the output gap as a predictor instead of the core inflation. Just like we do in our first exercise, now we consider the optimal combination between both forecasts, where the optimal weight is determined using expression (35):…”

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