Inflation dynamics under different weather regimes: Evidence from Mexico

Abstract

In countries with substantial agricultural sectors, such as Mexico, extreme weather conditions linked to the El Niño-Southern Oscillation (ENSO) wield significant influence. This study focuses on Mexico, examining how ENSO affects the interplay between headline inflation (excluding energy) and economic activity. Employing a nonlinear local projection within two weather scenarios – acute and neutral – we uncover a notable disparity in inflationary dynamics. Notably, amidst acute weather conditions, a 1% shock in the output gap triggers a cumulative inflationary effect (over a 12-month horizon) 0.90% higher than under neutral environmental states. This discrepancy deviates inflation from Mexico’s Central Bank target because of supply constraints and demand pressures which mainly affect agricultural inflation. The results emphasize the urgency of incorporating environmental factors into inflation risk assessment for more informed monetary policy decisions. Additionally, this approach aids in isolating environmental influences from other inflation drivers.