Mexico: Could we be underestimating upside risks to inflation?

Inflation ended 2020 at 3.2%, close to the Central Bank's 3% target. Core inflation, meanwhile, came in at a more elevated 3.8%, but lower than the 4.0% high in September. Expectations are for both headline and core inflation to converge towards the Central Bank's target in the course of 2021-2022. While supply disruptions put some upward pressure on inflation in the course of 2020, the wide spread view is that the prevalence of a large output gap on account of the COVID recession will ultimately prevail as the main determinant of price increases in the next two years. While we share this view, we are also sympathetic to Banxico's repeated warnings that the outlook for inflation remains highly uncertain and that the risks to inflation could be high both to the upside as well as to the downside. In this piece, we focus on the former: could we be underestimating upside risks to inflation this year?

To frame the discussion, it may help to highlight that inflation in 2020 was marked by two prominent divergent trends: i) headline inflation was sent lower on account of the sharp deceleration in non-core inflation, which fell to 1.2% last year, counterbalancing the high core inflation mentioned above; and ii) within core inflation, we witnessed the rise in merchandise goods prices (ending the year with 5.5% inflation), while service prices collapsed (with inflation of 2.0% by year-end. To a large extent, the outlook for inflation hinges on how these trends ultimately normalize. In what follows, we examine the risks to different components of core and non-core inflation.