The primary objective of the ECB is to keep prices stable. That means prices should not go up (inflation) significantly, and an ongoing period of falling prices (deflation) should also be avoided. This is because long periods of excessive inflation or deflation have negative effects on the economy.
What’s wrong with high inflation?
If the prices of many items you buy go up, you lose purchasing power. In other words, the money you have – your income and your savings – does not buy as much as it used to. This can lead to a spiral of increasing prices. The reason for this is that if everything is becoming more expensive, you may ask your employer for a salary increase. Your employer may react by raising the company’s prices to fund the requested salary increases of staff. If this is happening in many companies, the prices of many items will rise further, and so the spiral continues. This makes it more difficult for you and for businesses to plan savings and investments. People may lose confidence in the currency as it is losing value rapidly. These are just a few examples of the negative side effects of high rates of inflation.
What’s wrong with extended periods of deflation?
Falling prices might sound good to you as a consumer. And indeed they can be good if it is just a few items that are going down in price. For example, in recent decades the prices of many electronic devices, such as laptops and phones, have fallen, largely due to innovation, which makes it possible to save on production costs.
However, an ongoing and widespread fall in prices across the economy that is not due to improvements in production is not such a good thing. This is because it can lead to a spiral of falling prices. For example, if you have your eye on a new sofa, but you know the price will go down if you wait a little before buying it, you will probably do just that. If everyone acts in the same way, businesses start to suffer 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. It might also become more difficult to pay off any debts you may have, such as your mortgage, which will not decrease even though your income might.
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.
Putting a figure on price stability
Keeping prices stable is the best contribution central banks can make to improving people’s individual welfare, which is why the Treaty on the Functioning of the European Union set it as the ECB’s primary objective. In order to achieve this objective, the ECB has made a quantitative definition of price stability. It aims for an annual rate of inflation of “below, but close to, 2% over the medium term”, as measured by the Harmonised Index of Consumer Prices (HICP).
This gives you a yardstick against which you can measure the ECB’s performance. It makes the ECB’s actions transparent. It means you can plan for the future better, knowing how much you can expect prices to change in the euro area, on average, over time.
The ECB’s price stability objective is for inflation in the euro area as a whole. It takes a medium-term perspective, considering the inflation rate over time rather than focusing on short-term peaks and troughs because they even out with time and cannot be controlled by monetary policy.
Why below, but close to, 2%?
If the ECB wants prices to remain stable, why does it aim at inflation of below, but close to, 2% over the medium term, and not of 0% or 1%? There are a number of reasons for this.
To account for the fact that inflation figures can be slightly overstated.
To have a safety margin against the potential risks of deflation.
To leave room for differences in inflation across euro area countries.
The ECB takes into account the possibility that inflation figures (as recorded by the HICP index) can be slightly overstated because of the way it is measured. One example of how this can happen is if the price of an item included in the basket of goods used to calculate the index increases because the quality of the product has improved, e.g. a car with better safety technology compared with an older car. If the calculation of inflation does not fully account for the fact that the price change is due to the improvement of the product, this will result in a higher reading for inflation than is the case.
Inflation of below, but close to, 2% provides a safety margin against the potential risks of deflation. In the event of deflation, the usual monetary policy tools (i.e. changes in key interest rates ) will find limits. There comes a point when it does not make sense for a central bank to cut rates much further. In addition, even controlled inflation tends to fluctuate over time around an average value. So, by incorporating a buffer in the objective above zero, the central bank will have to revert less frequently to unconventional measures, such as quantitative easing or longer-term refinancing operations.
Differences across euro area countries
The ECB maintains price stability for the euro area as a whole. Aiming for inflation of below, but close to, 2% leaves room for differences in inflation rates across euro area countries, which ideally should average out over time. An objective above zero helps to prevent some countries or regions having to live with excessively low or even negative inflation rates to counterbalance other countries that may be experiencing higher inflation rates.
Source: European Central Bank
Published: 8 May 2017
The above presentation was created for educational purposes.