zero, it is helpful if inflation is some low positive number to make negative real interest rates possible. the second school of thought argues for a lower inflation target, often characterised by 0 to 2 percent but sometimes expressed as the level of average prices remaining stable over time. those who favour this view discount the arguments advanced by the ‘ low positive ’ school. they acknowledge that there is an upward bias in the way in which inflation is measured, but argue that in most countries outside the united states that bias is almost certainly less than 1 percent and certainly could not justify a target with a mid - point of 2 percent. ( the new zealand government statistician is strongly convinced that there is less bias in the measurement of the new zealand cpi than there is in the measurement of the us cpi. ) they acknowledge that it has not been easy to adjust nominal wages downwards in recent years, but argue that in substantial part that is a result of the persistently high inflation most countries have experienced in recent decades, so that that should be no more than a transitional problem. moreover, even though it may be difficult to reduce the wages of an individual employee, that does not prevent a significant reduction in unit labour costs as a result both of unchanged wages and positive productivity, and of natural turnover in the labour force. critics of the ‘ low positive ’ school challenge the assertion that monetary policy occasionally needs to reduce real interest rates below zero, and note other ways in which monetary policy can stimulate demand, particularly in very open economies where movements in the exchange rate play an important role in influencing aggregate demand in the short term. those favouring very low inflation ( 0 to 2 percent ) argue that not only are there no advantages in tolerating a ‘ low positive ’ rate of inflation there are also significant disadvantages of even quite low rates of inflation. thus for example martin feldstein of harvard university ( and current president of the national bureau of economic research in the us ) argues strongly that even very low levels of inflation significantly exacerbate the biases in the tax system which encourage consumption, discourage saving, and encourage excessive investment in residential property. in a recent paper he argued that reducing measured inflation from 3 percent to 1 percent in the united states would result in a permanent increase in the level of us gdp of 1 percent, a very large gain in economic well - being even if there is some temporary loss of output required to reduce inflation to that level. others have also argued that the interaction between inflation on the one

adequacy is not on favourable or benign economic conditions, or on the " expected " losses that occur as a normal part of banking business those matters should be addressed through provisioning. rather, the focus is on unexpected loss associated with severe downturns in the economy's performance. " stress testing " for such scenarios is required under basel ii, and the scenarios need to account fully for the behaviour of systematic risk. for example, stress scenarios should address the risk of a downturn leading borrowers'risks to correlate more closely, undermining the diversification strategies rightfully adopted by banks to manage risk in normal times. experience shows that downturns in the housing market do happen and can cause significant losses to banks and to the financial system as a whole when they do. the reserve bank will be working to ensure that any internal models used by an accredited bank produce capital estimates that are based on " through the cycle " loss experience - that is, after adjustment for the peaks and troughs in observed losses that occur over the business cycle in new zealand. notwithstanding this emphasis on through - the - cycle loss experience for the purposes of internal modelling, it will also be important to ensure that capital management processes in practice deliver fairly stable capital outcomes through the business cycle. for example, a failure to adjust fully for the business cycle when incorporating loss experience into modelling processes could lead to capital falling during upturns in the cycle and rising during downturns, which would exacerbate the cycle through promoting lending growth during upturns and lending contraction during downturns. capital settings should be for the long haul, and need to be robust over many business cycles and through a range of economic circumstances. an important outcome we will be seeking from our basel ii implementation is that the capital management processes within banks ( both those using internal models and those using standardised approaches ) ensure that adequate " buffer " capital is always held in anticipation of any need to manage any residual " procyclicality " in the outputs of internal modelling processes. as well as making minimum capital requirements more risk - sensitive, basel ii also includes the principle of sharpening the focus of engagement between supervisors and banks on ensuring that a bank's capital management process adequately accounts for the risk of unexpected loss. the quality of this process and the manner in which the outputs from internal models are used within the bank's governance and risk management more generally will be a key part of the assessment for a bank