Key Points:

The system of inflation targeting pioneered by New Zealand was serving it well despite the annual inflation rate being at 4 per cent and expected to hit 5 per cent this quarter, Reserve Bank Governor Alan Bollard said today.

Speaking at a function in Auckland, he warned not too much should be asked of the scheme that was introduced nearly two decades ago.

"Inflation targeting is the best approach New Zealand and many other similar countries have yet found for monetary policy, among a limited number of viable alternatives," he said.

Some economists and analysts have questioned the suitability of the system because it is associated with wild swings in the currency that make it difficult for exporters to operate.

Critics note that New Zealand has among the highest interest rates in the developed world despite being well into a recession.

The bank is mandated to keep inflation between one and three per cent over the business cycle but is also allowed to discount external shocks such as oil price rises.

Bollard said current circumstances were very difficult due to the effects of oil and food price rises, but "the flexible inflation targeting framework positions us well to manage the ongoing shocks impacting the New Zealand economy".

He said monetary policy worked best in an environment where wider government policies promoted economic stability.

"Together, they help maximise long-run growth performance and prosperity. But what is also needed is savings and investment behaviour geared towards growth."

Parliament's finance and expenditure select committee has been investigating the monetary policy framework and is due to report soon, but commentators do not expect it to propose significant changes.

Bollard said the New Zealand economy is subject to powerful forces and monetary policy can only do so much to buffer the shocks. "When shocks are persistent, as with oil and food prices currently, it is difficult to judge the appropriate response.

"Such price rises are driven by international supply and demand. The extraordinary oil price rise in particular has left New Zealand poorer and we all need to recognise this."

Food prices have leapt 8.2 per cent in the year to June.

"Even if we wanted to, we could not stop such prices rising," Bollard said.

"We need to allow the initial price changes to occur, but keep monetary policy firm enough to ensure that generalised second-round inflation effects do not take hold.

"Quite simply, we cannot all pass on the higher costs to our customers or employers. If we do try to pass it on, then monetary policy will respond."

Bollard said New Zealand's high real interest rates reflected the need to restrain inflation pressure that had built up in recent years.

"The current weakness in the economy allows room for rates to be cut, while ensuring inflation, and inflation expectations, come down over the medium term to within the target range."

He said the clear "medium-term" objective of 1-3 per cent inflation helped to anchor inflation expectations "and gives us more scope to accommodate short-term inflation shocks while ensuring that the price stability objective is not undermined in the process."

That a large and growing number of countries had copied the New Zealand inflation targeting system suggested it was a good system, he said.