The Case for a Positive Euro Area Inflation Target: Evidence from France, Germany and Italy

Using micro price data underlying the Harmonized Index of Consumer Prices in France, Germany and Italy, we estimate relative price trends over the product life cycle and show that minimizing price and mark-up distortions in the presence of these trends requires targeting a significantly positive inflation target. Relative price trends shift the optimal inflation target up from a level of zero per cent, as suggested by the standard sticky price literature, to a range of 1.1-2.1 per cent in France, 1.2-2.0 per cent in Germany, 0.8-1.0 per cent in Italy, and 1.1-1.7 per cent in the euro area (three-country average). Differences across countries emerge due to systematic differences in the strength of relative price trends. Other considerations not taken into account in the present paper may push up the optimal inflation targets further. The welfare costs associated with targeting zero inflation turn out to be substantial and range between 2.1 and 4.5 per cent of consumption in present-value terms.