Price stability implies avoiding both prolonged inflation and deflation.
Inflation is a rise in the in the general price level of goods and services in an economy over a longer period of time resulting in a decline in the value of money and purchasing power. Deflation is a decrease in the general price level of goods and services over a longer period of time. Too rapid inflation is negative for many reasons: it complicates the economic decision-making process and slows economic growth. In addition, inflation diminishes the value of savings. Deflation is accompanied by the threat of a slowdown in economic growth, because the general level of prices declines, and thus, people postpone consumption and companies postpone investment. There may emerge an inflationary gap which is very difficult to overcome. The real value of loans that are not repaid increases, which means that borrowers run into difficulty, and loan losses pose a threat to financial institutions as well. Often, enterprises find it hard to lower wages, even if the price of their output declines. This causes an increase in unemployment and in the number of bankruptcies.
- Price stability contributes to achieving high levels of economic activity and employment by
- improving the transparency of the price mechanism. Under price stability people can recognise changes in relative prices (i.e. prices between different goods), without being confused by changes in the overall price level. This allows them to make well-informed consumption and investment decisions and to allocate resources more efficiently;
- reducing inflation risk premia in interest rates (i.e. compensation creditors ask for the risks associated with holding nominal assets). This reduces real interest rates and increases incentives to invest;
- avoiding unproductive activities to hedge against the negative impact of inflation or deflation;
- reducing distortions of inflation or deflation, which can exacerbate the distortionary impact on economic behaviour of tax and social security systems;
- preventing an arbitrary redistribution of wealth and income as a result of unexpected inflation or deflation.
Quantitative definition of price stability
In 1998, the ECB Governing Council formulated the quantitative definition of price stability: "Price stability is a year-on-year increase in the Harmonised Index of Consumer Prices (HICP) for the euro area of below 2%. Price stability must be maintained over a medium-term perspective." In addition, in May 2003 the Governing Council also clarified that, in the pursuit of price stability, it aims to maintain inflation rates "below, but close to, 2% over the medium term".
Why "below, but close to 2%"?
The inflation rate below but close to 2% is low enough to allow the economy to benefit fully from price stability.
- It also stresses the Eurosystem's obligation to guarantee the appropriate inflation rate in order to
- avoid deflation risk. This is important to keep the nominal interest rates above zero. In a deflationary environment monetary policy may not be able to sufficiently stimulate aggregate demand by using its interest rate instrument. This makes it more difficult for monetary policy to fight deflation than to fight inflation. One should also take into account the possibility of HICP inflation slightly overstating true inflation as a result of a small but positive bias in the measurement of price level changes using the HICP;
- provide a sufficient margin to address the implications of inflation differentials in the euro area. It avoids that individual countries in the euro area have to structurally live with too low inflation rates or even deflation.