The importance of price stability
The Eurosystem’s objective of maintaining price stability refers to the general level of prices in the economy and implies avoiding both persistent and high inflation or deflation. There are several ways in which price stability contributes to achieving high levels of economic activity and employment.
The overriding importance of the price stability objective in monetary policy mirrors the broad consensus among economists that monetary policy only has a temporary impact on real economic variables (such as e.g. economic growth and unemployment). In the long run, monetary policy only has an influence on monetary variables; this means that steering the increase of price levels (i.e. the inflation rate) naturally falls within the remit of monetary policy makers.
The benefits of price stability
Price stability proves beneficial for the economy in several ways:
- It makes it easier for people to disentangle changes in prices of individual goods or services from changes in the general price level. This in turn allows the market to allocate resources more efficiently.
- If prices are stable, inflation risk premiums in financial markets go down, which means that real interest rates go down as well. Lower interest rates, in turn, increase the incentives to invest.
- In an environment of price stability, businesses and other economic agents do not have to hedge against inflation and can therefore put the available resources to productive use.
- The nominal orientation of tax and social security systems creates distortions in the economy, which may be kept in check by lower inflation.
- Price stability reduces the arbitrary redistribution of wealth and income that arises in inflationary and deflationary environments.
- Price stability contributes to financial stability.
The Eurosystem’s price stability objective
The Eurosystem defines price stability as a year-on-year increase in the Harmonised Index of Consumer Prices (HICP) for the euro area of below, but close to, 2% over the medium term. The Governing Council of the ECB, the policy-making body of the Eurosystem, decided to publicly announce this quantitative target of price stability for a number of reasons:
- By specifying a clear quantitative target, the Eurosystem contributes to making its monetary policy framework easier to understand and its monetary policy more transparent.
- This way the Eurosystem provides a clear and measurable yardstick against which the public can hold it accountable.
- Finally, the quantitative definition provides guidance to the public when forming expectations of future price developments.
The Eurosystem’s monetary policy is focused on the entire euro area. Hence, price stability is assessed on the basis of price developments in the euro area as a whole and does not consider price developments in individual euro area countries.
By referring to “an increase in the HICP of 2%” in its definition of price stability, the Eurosystem makes clear that both an inflation of above 2% and deflation (i.e. a self-reinforcing decline in the general price level) are inconsistent with its definition of price stability.
The transmission of monetary policy impulses to the price level in the real economy is normally characterized by considerable time lags. Since monetary policy cannot influence the inflation rate over the short term, the Eurosystem included a medium-term horizon in its definition of price stability.
The Eurosystem’s definition of price stability refers to a particular price index, namely the Harmonised Index of Consumer Prices (HICP) for the euro area. This index was harmonized across the various countries of the euro area.