In economies with important price indexation mechanisms, one of the greatest challenges of a disinflationary monetary policy is to make price setters form expectations (and thus set prices) on the basis of forward-looking variables instead of looking back into the past. Under a credible inflation-targeting regime, looking forward means believing in the inflation targets announced by the central bank.
Some Latin American central banks that explicitly target inflation have reacted strongly to deviations of inflation expectations from announced targets. Fraga, Goldfajn, and Minella argue that the strong reaction of the Central Bank of Brazil to private inflation forecasts suggests that "the Central Bank conducts monetary policy on a forward-looking basis and responds to inflationary pressures."1 In Mexico, Torres García also finds evidence that monetary policy responds to forward-looking variables, such as inflation expectations, rather than to backward-looking ones.2
The literature on optimal monetary policy has traditionally been built on the assumption that agents' expectations are rational, which implies that price setters perfectly know the structure of the model governing the economy and all the parameters of that model.3 However, this assumption is not innocuous to optimal monetary policy. Orphanides and Williams demonstrate that when expectations are updated every period from a finite sample regression, which seems to be what real-life econometricians do, the central bank should react [End Page 101] more strongly to deviations of expectations from the desired inflation path than under rational expectations.4 Evans and Honkapohja, as well as Woodford, also show that some particular forms of monetary policy rules cause instability in a macroeconomic system if forecasters learn over time instead of being unboundedly rational.5
Given the importance of inflation expectations to monetary policy decisions, it is crucial to identify the rationality embedded in the forecasts to which central banks react. One of the main purposes of inflation-targeting regimes is to anchor inflation expectations; understanding how these targets feed into the expectations' formation rule is therefore also relevant. Should inflation targets cease to be an anchor for inflation expectations, inflation stabilization costs would be higher.
This paper tests the rationality of private inflation forecasts surveyed by the University of Chile, the Central Bank of Brazil, the Bank of Mexico, and Infosel (a Mexican news agency).6 The central banks of Brazil, Chile, and Mexico consider these surveyed forecasts in their inflation reports and, to varying degrees, see them as important indicators of future inflationary pressures. The results we obtain provide very strong evidence that private inflation forecasts in Brazil, Chile, and Mexico are unbiased, although this conclusion can be sensitive to the econometric technique employed.
In Chile, if we allow for serial correlation in the errors, reported forecasts for twelve-month-ahead inflation are also efficient in the use of relevant macroeconomic [End Page 102] variables. In Brazil and Mexico, at least one macroeconomic variable could be better used to improve the accuracy of private inflation forecasts, which suggests that the economic model governing the inflation dynamics in these countries is not entirely understood.
In Mexico, we find strong evidence of inefficiency in the use of overnight and twenty-eight-day interbank interest rates for all forecasting horizons investigated. Our immediate candidate to explain this inefficiency is the choice of monetary policy instrument. Contrary to most inflation-targeting countries in the world, the Bank of Mexico's operational instrument is the monetary base rather than interest rates.
In Brazil, efficiency tests are highly sensitive to the econometric technique employed and the forecasting horizon analyzed. Median twelve-month-ahead forecasts are, in fact, efficient in the use of information on wholesale price inflation and the exchange rate. This suggests that the median forecaster understands the long-term effects of supply shocks on inflation. However, median short-term forecasts (namely, three and six months ahead) do not use such information efficiently. As is standard...