in these circumstances, we have real choices about how to respond. we can either let any further anticipated direct inflation consequences of the shock come through, or try to offset them with tighter policy than otherwise. the pta does not explicitly address long - lasting shocks, but as noted before, it does provide sufficient guidance and scope for the reserve bank to take a sensibly flexible approach. the basic approach of looking through the near - term, unexpected inflation impact is the same. however, the key judgement with this kind of persistent, high - profile shock is about the heightened risk that the period of elevated headline cpi inflation might lead the public to question the reserve bank ’ s commitment to the medium term inflation target, and plan and act on the basis of a higher expected inflation rate. getting inflation expectations down again can be very costly, as shown by new zealand ’ s own economic history – let alone the history of countries that have experienced hyperinflation such as the weimar republic in the 1920s, argentina in the 1980s and zimbabwe currently. figure 5. cpi inflation and inflation expectations sources : statistics nz, rbnz. there is thus much less scope to be sanguine about long - lasting price shocks compared to sudden and ephemeral shocks, because the risk is greater that inflation expectations could drift away from the target range. currently, inflation expectations appear to remain anchored at a level consistent with the target range, though there is a slight upward drift, apparently reflecting the sustained elevation of headline inflation ( figure 5 ). the key requirement in this sort of situation is that policy is kept tight enough to ensure that inflation expectations remain anchored. sustained oil price inflation is just one stark example of a shock that might persist for some time. there are actually two other large and sustained shocks all at work on the new zealand economy at the moment : a retrenching housing market after the biggest housing boom ever, and very strong dairy prices. also, very large increases in other commodity prices such as steel and fertiliser, while having a smaller direct effect on cpi, have had a substantial impact on business costs in some sectors. the appropriate response to the housing market downturn is fairly straightforward, because it is a demand - driven shock. with weak domestic spending, loosening policy to bring demand closer to the economy ’ s supply capacity is also consistent with keeping future inflation on target. the dairy price shock is more difficult, as it combines a positive stimulus to demand ( increased income for dairy farmers and associated

over the medium term to be within the target band. the public expects us to meet our target, and this helps to keep expectations anchored. very few of the countries who have adopted inflation targeting have given it up. alternatives that dilute the focus on medium term inflation and price stability could seriously threaten the anchoring of inflation expectations and damage the credibility of the new zealand macroeconomic policy framework, especially in the current environment of high rates of headline inflation and strong forces on the economy. references roger, s and m stone ( 2005 ) “ on target? the international experience with achieving inflation targets ”, imf working paper wp / 05 / 163.