Monetary policy mission

Price stability

The primary objective of the Eurosystem's monetary policy is to maintain price stability.

The Governing Council of the European Central Bank (ECB) has adopted a quantitative definition of price stability. The ECB aims at an annual inflation rate of below, but close to, 2% over the medium term, as measured by the Harmonised Index of Consumer Prices (HICP) for the euro area as a whole.

The definition of price stability is based on the following elements:

  • The key measure of price developments in the euro area is the Harmonised Index of Consumer Prices (HICP), which is released by Eurostat and is harmonised across the euro area countries, in order to ensure that price developments are measured on a comparable basis. The HICP is the best measure of the average change over time in the prices paid by households for a representative basket of consumer goods and services in the euro area.
  • The definition refers to the inflation rate in the euro area as a whole and, accordingly, single monetary policy decisions are made from a euro area-wide perspective. Moreover, in a monetary union, monetary policy can steer the average level of money market interest rate in the area as a whole rather than in individual  member countries. This is so because there is a common currency (euro), and thus monetary policy rates are also common for all member states of the euro area.
  • Price stability has a medium-term orientation, focusing on the inflation rate over considering the inflation rate over time rather than focusing on short-term peaks and troughsthat are typically due to  exogenous and short-lived factors.

Without prejudice to the primary objective of price stability, the Eurosystem's monetary policy supports the general economic policies of Member States with a view to contributing to the achievement of their objectives. These include inter alia full employment and balanced economic growth.

Why is price stability important?

Price stability is important because it preserves the euro's purchasing power.

Price stability is important because it preserves the euro's purchasing power.

If, for instance, EUR 100 can buy the same basket of goods as it could, say, one and two years ago, then this can be called a situation of absolute price stability.

Since the euro was created on 1 January 1999, the average rate of inflation in the euro area has been 1.7%, i.e. lower than the average inflation rates prevailing  in the Member States pre-EMU, during the 70s, 80s and 90s.

Problems caused by a protracted price rise or fall

A persistent, broadly-based increase in the prices of consumer goods and services over a protracted period (inflation) leads to a decline in purchasing power. 

A persistent, broadly-based increase in the prices of consumer goods and services over a protracted period (inflation) leads to a decline in purchasing power. This can lead to a spiral of rising prices, thereby making it more difficult for consumers and for businesses to plan savings and investments. People may lose confidence in the currency as it is losing value rapidly.

On the other hand, deflation, i.e. an ongoing and widespread fall in prices across the economy that is not due to improvements in production can also have negative repercussions. This is because it can lead to a spiral of falling prices.

For instance, consumption can  be systematically postponed in anticipation of lower prices in the future. Businesses  will start facing problems as they cannot sell their products. They might need to reduce or freeze wages or even cut staff numbers as demand falls, leading to a rise in unemployment. The economy will start slowing down as consumers and businesses cut back on spending and investing.

The same goes for public finances. Tax revenues decline as incomes and spending decrease, but government debt will still have to be paid. As a result, public spending on infrastructure and healthcare, for example, might need to be reduced. The negative consequences of deflation are therefore felt by everyone.

In conclusion, protracted periods of high inflation or deflation have adverse effects on the economy.

Keeping  prices stable is the contribution central banks can make  to improving people’s individual welfare, which is why Treaty on the Functioning of the European Union set it as the ECB’s primary objective. This objective reflects lessons learned from history and a broad consensus that, by maintaining price stability, monetary policy contributes significantly to sustainable growth, economic welfare and job creation. 

How can central bank decisions affect prices?

The central bank has the exclusive privilege of issuing currency, i.e. is the monopoly supplier of the monetary base, therefore it is able to influence  the cost and availability of money.

The central bank has the exclusive privilege of issuing currency, i.e. is the monopoly supplier of the monetary base, therefore it is able to influence  the cost and availability of money.

A change in these factors triggers a number of mechanisms, as well as responses by economic agents, thus affecting economic variables such as output or prices.

This process is called "monetary policy transmission mechanism" and is quite complicated. A simplified version focusing on the interest rate channel is described below.

One of the key tools of any central bank is setting policy interest rates, namely the cost of money.

By changing its policy  rates, the central bank determines  the cost at which commercial banks borrow from the central bank. In this manner, it influences both the interest rates at which commercial banks borrow from each other and bank lending conditions for households and enterprises.

Given that the level of borrowing rates plays generally a significant role in consumption and investment decisions by households and enterprises, monetary policy decisions, by extension, affect overall demand and, ultimately, price developments.

What is the role of commercial banks?

Commercial banks obtain liquidity from the central bank and use  it e.g. to extend  loans to enterprises and households, as well as to other banks. 
Commercial banks obtain liquidity from the central bank and use  it e.g. to extend  loans to enterprises and households, as well as to other banks. Thus, they play a significant role in the pass-through of  central bank rates to money market rates and, in turn, to the interest rates on lending to the real economy. In the euro area in particular, where enterprises and households rely much more on to bank credit than on other financing sources, commercial banks play a leading role in the transmission of monetary policy decisions to the economy and are effectively the main channel through which the ECB’s monetary policy stance is transmitted into the economies of individual countries.
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