An optimal inflation target for New Zealand: lessons from the literature

Abstract

In this article we summarise the recent economic literature on the relationship between inflation and growth, to assess what inflation target might be most consistent with the fastest pace of sustainable economic growth. One conclusion is that the relationship between inflation and growth seems to be different at different rates of inflation. At very low rates of inflation, including the 0 - 3 per cent range, the growth rate seems to be independent of the inflation rate. But at higher rates of inflation, there is evidence that inflation does significant damage to growth. There is some theoretical literature which cautions central banks against deflation, and therefore against including zero in an inflation target range. As yet there is little data available with which to test this presumption. Based on the theoretical arguments, we conclude that the risks of New Zealand being caught in a deflationary trap are low. Overall, we conclude that average rates of inflation in New Zealand have been within the `optimal inflation range' suggested by the literature. Interested readers may wish to consult a longer and more comprehensive version of this paper, contained in the Bank's publication on PTA related issues.

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