Measuring Core Inflation in a Small, Open and Dollarized Economy : The Peruvian Case

In the last years four Latin American countries (Chile, Colombia, Mexico and Peru) have switched to inflation targeting as the main mechanism to guide their monetary policies. In this paper we address some of the basic questions regarding its implementation: (i) which inflation measure should use: core vs headline; (ii) how forecastable are these measures of inflation; and (iii) how effective is the monetary policy to control its behavior. The paper follows the steps of Bryan and Cecchetti (1993). However, all these questions have specific qualifications in a small, open and dollarized economy in which the ability of the Central Bank might be eroded by currency substitution problems. We found that the Peruvian Central Bank should target the CPI inflation but conduct its monetary policy forecasting a core inflation measure in a 12-month horizon as the currency substitution problem does not seem to impose a severe restriction as previously analyzed in Moron (1997)