Itaú BBA - Itaú Inflationary Surprise Index - Inflationary relief in LatAm

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Itaú Inflationary Surprise Index - Inflationary relief in LatAm

August 29, 2016

The disinflation process should continue in the region due to weak economic activity and more favorable exchange rates.

Surprise indices have been around for some time. They measure the extent to which forecasts of economic variables match their realized values. Coupling the index to economic performance is, however, not straightforward. The size of a surprise may be the result of estimates astray from reality, rather than reality taking an unprecedented turn. Nonetheless, surprise indices have been a reasonable guide to the market’s overall mood, which reflects on asset prices. In this fashion, the concept of economic surprise is appealing, for many studies show that asset prices depend largely on expectations (e.g. Engel & West, 2005 show this with exchange rates). Since 2012, we have covered surprises for economic activity in Latin America. Four years later, our Itaú Activity Surprise Index meets a new cousin: the Itaú Inflationary Surprise Index.

The inflation surprise index serves the same purpose and shares the same methodology as the activity surprise index: it compares trends in inflation indicators (rather than activity indicators) released during the month to what analysts had been expecting for them. Like the activity index, the inflation index is a GDP-weighted average of separate indices for Brazil, Mexico, Chile, Colombia and Peru.[1]. The inflation index, however, possesses fewer indicators for each country due to the limited number of inflation indices that are consistently forecasted by agents. As usual, an above-zero reading means inflation overshot estimates. A below zero reading means inflation came in lower than expected. The index is a three-month moving average in order to avoid excess volatility.

A heated economy usually means higher inflation and vice-versa - the relationship holds generally with our activity and inflation surprise indices. Nevertheless, they do not always move in tandem. In some windows of time, the two indices diverge, sometimes going opposite directions. This is not surprising, as the variables are susceptible to lead-lag effects. For example, Brazil’s inflation rate has just recently started to respond to the longtime weakness in activity. Besides lead-lag effects, episodes of stagflation – where activity is falling and inflation is rising - may also drive the two apart (this is not uncommon when, as in Brazil in 2015, price controls and subsidies are scrapped). Take for instance the diversion in the LatAm activity and inflation surprise indices from mid-2014 to mid-2016. This was due in large to the toppling of commodity prices, which depreciated LatAm and Emerging market currencies and worsened terms of trade, pressuring inflation rates and slowing growth simultaneously, plus the cited removal of subsidies and controls. Overall, the two indices tend to move together, but it is no less interesting to observe the times when they deviate, and how central banks might react upon such information.

A few observations can be made when analyzing the co-movements of individual indices in the region. The most blatant correlation is noticed among the Andean economies (Chile, Colombia and Peru). Mexico co-moves with the Andean economies to some degree, and less with Brazil. Lastly, Brazil’s index presents the least correlation with all others, although it tends to correlate more with the Andean economies than with its more distant partner, Mexico[2].

After the FX depreciation shock that drove LatAm’s inflation surprise index close to its historical highs during the 2014-2016 period, these upward surprises have diminished considerably since February - some even turning negative - meaning that the market has started to overestimate inflation. Easy global monetary policy has stimulated risk appetite, and the consequent appreciation of LatAm currencies eased pressures on inflation and inflation expectations in the region. Mexico has been boasting low inflation for a while (although gradually rising at the margin); its surprise index navigates in the negative territory. In Chile, the gradual disinflation process continues, with inflation approaching the central bank’s target, and its surprise index also stands in negative territory. Inflation in Peru is going through a similar story. Despite this recent trend of improvement in LatAm, a more recent hiccup in food prices has pressured inflation in Brazil and Colombia (which together account for 64% of the index), bringing back upward swings in surprises and impacting the aggregate index. This phenomenon also happened in the last couple of months in Peru, where inflation drifted above the target range for many months, fueled by foodstuff price spikes (and a depreciated exchange rate), but these temporary shocks have receded recently, and so has inflation. We believe food price pressures in Brazil and Colombia are also temporary due to the El Niño, and that the disinflation process will continue in the region as a whole, a product of weak economic activity and a more favorable evolution of exchange rates assuming that global financial conditions remain favorable. This, in turn, will make room for the region’s central banks to adopt looser monetary policy stances, meaning that some central banks would cut rates while hikes in others become very unlikely.

Methodology Note

Our Itaú Inflationary Surprise Index compares trends in inflation indicators to what analysts had been expecting for them each month. The index considers the month that each indicator is released. For instance, February’s inflation reading released in March will be incorporated to March’s surprise index.

The index is a GDP-weighted average of separate indeces for Brazil, Mexico, Chile, Colombia and Peru. An above-zero reading means inflation overshot estimates. Below zero means inflation came in below expectations. The index is a three-month average in order to avoid excess volatility.

We build the inflation surprise index for each country using inflation indicators for which consensus estimates are normally provided in the Bloomberg survey. The weight of each indicator in the index depends on its importance for the economy. For example, headline consumer inflation numbers enjoy a higher weight than regional inflation indicators or wholesale price indices.

We use the deviation of the actual print from the consensus estimate (surprise), subtract the result from the historical average deviation and then divide the result by the standard deviation of the surprise. This methodology provides a better sense of how important was the surprise in each month.

The weight of each country in the aggregate inflation index depends on the size of its GDP. Brazil has the highest weight, followed by Mexico.

It’s worth noting that, due to revisions in the economic indicators and as lagged announcements, the surprise indices may be revised.

Indicators on which the index is built: 

Brazil: IPCA (Headline CPI) (30%), IPCA-15 (30%), IGP-10 (10%), IGP-M (10%), IGP-DI (10%), IPC-S (5%), IPC-FIPE (5%)

Mexico: Headline CPI (50%), Bi-Weekly CPI (50%)

Chile: Headline CPI (100%)

Colombia: Headline CPI (100%)

Peru: Headline CPI (100%)

[1] See full methodology note below.

[2] See correlation matrix below.


Laura Pitta
Lourenço Paiva



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