High and volatile inflation has adverse consequences for the economy. It can reduce investment and job opportunities and increase inequality in society. Similarly, inflation that is too low can be detrimental. Since it is generally difficult for companies to lower nominal wages, their ability to pay wages is reduced if the prices of their goods and services increase too little or decrease. Companies would therefore have to hire fewer employees or even resort to lay-offs to reduce labour costs. In this way, too little inflation causes the employment level to fluctuate more when economic shocks occur, which is costly for society. The same can be said of real interest rates, as it is difficult to reduce nominal rates far below 0%.
A target of 0% inflation would elevate the risk of sustained periods of deflation. Prolonged deflation would cause nominal debt to increase in real terms and the real service burden of outstanding loans to increase. If the price of goods and services has fallen but the amount of non-indexed loans does not change in accordance with the price level, a company would, for example, have to produce and sell more goods and services to be able to repay the loan. One could therefore actually have to pay more, even though the amount of the loan has not changed. This can cause payment difficulties and therefore lead to a recession.
Households and businesses may also hold back on spending decisions as they wait for prices to fall further. In that case, both manufacturers and retailers sell fewer goods and services, which means that their revenues and profits decline. Companies then respond by reducing their production and hiring fewer people or laying off staff. Unemployment will then be higher than it would have been otherwise and the people affected will have less income, causing them to buy even fewer goods and services, etc. This deepens the recession even further. Historically, periods of deflation have created problems, and the vicious cycle of deflation and economic recession can prove difficult to deal with.
The conclusion is therefore to aim for inflation to be low, but somewhat above 0%. According to the joint declaration made by the Central Bank of Iceland and the Government, the inflation target is defined as an inflation rate of 2½%. This is in line with the practice in other advanced economies where the inflation target is typically set in the range of 2-2½%.