Modeling the trend, persistence, and volatility of inflation in Pacific Alliance Countries: an empirical application using a model with inflation bands

Abstract

This paper estimates and analyzes the dynamics of trend inflation, as well as the persistence and volatility of the inflation gap, in the Pacific Alliance countries (Chile, Colombia, Mexico, and Peru). The econometric approach employs methodologies proposed by Stock and Watson (2007) and Chan et al. (2013), including the AR-Trend-Bound model, which incorporates the implications of inflation targeting in estimating the unobserved components of inflation. The results show that this model effectively attributes most of the permanent component to trend inflation. Additionally, all four countries exhibit a declining trend inflation during the 1990s, stabilization in the first two decades of the century, and a growing trend inflation following the onset of the COVID-19 pandemic. The low levels of inflation gap persistence before the pandemic reflect the effectiveness of central banks in keeping inflation close to its trend level. Lastly, the volatility of the inflation gap captures the Great Moderation of inflation, with pandemic-era increases in volatility reaching levels comparable to those observed in the 1990s.