Importance of price stability
Price stability means avoiding prolonged periods of excessively high inflation or deflation.
Inflation is a rise 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 by contrast is a decline in the general price level of goods and services over a longer period of time. Excessively high inflation is harmful for several reasons, as it makes it harder to take economic decisions and slows growth in the economy, while it also diminishes the value of savings. Deflation comes with the threat of growth in the economy slowing because the decline in the general level of prices leads people to postpone consumption and companies to postpone investment. This can create a deflation trap that is very hard to escape from. The real value of loans that have not been repaid increases, pushing borrowers into difficulties, with loan losses then consequently posing a threat to financial institutions. Employers often find it hard to cut wages, even if the price of what they produce is falling. This leads to a rise in unemployment and in the number of bankruptcies.
Price stability helps in achieving higher employment and increased economic activity, as it:
- increases transparency, as a stable price level helps people to understand better the relative change in prices when the price of one product changes against that of another, without a change in the overall price level causing confusion. This lets them make sensible decisions about consumption and investment and use their money more efficiently;
- reduces the inflation risk premiums in interest rates, because if creditors are confident that prices will remain stable in the future, they do not add any additional charge to cover the inflation risk of holding assets. This then lowers real interest rates and makes investment easier;
- makes it less likely that individuals and businesses will protect themselves against inflation or deflation, by tying amounts to be paid under contracts to changes in prices for example. High inflation can also lead to hoarding of non-monetary assets like real estate;
- reduces the distortions that tax and social systems can cause to the behaviour of participants in the economy. Inflation or deflation can make those distortions worse, as budget systems do not usually allow tax rates and social insurance payments to be indexed to the inflation rate;
- helps avoid redistribution of incomes and wealth as a consequence of unexpected inflation or deflation. Unexpected inflation or deflation has the biggest impact on the most vulnerable groups in society, who are usually less able to protect themselves against such movements in prices.
The quantitative definition of price stability
In 1998, the Governing Council of the ECB defined price stability quantitatively as: "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." The Governing Council further clarified in May 2003 that in the pursuit of price stability it was aiming to maintain inflation rates at "below, but close to, 2% over the medium term". In July 2021 the Governing Council then published its updated monetary policy strategy, which considered that the best way to maintain price stability is to aim for inflation in the euro area of 2% over the medium term. The inflation target is symmetrical, meaning that both negative and positive deviations from the target are considered equally undesirable.
An inflation rate of 2% is low enough to allow the economy to benefit fully from price stability while also stressing the Eurosystem's obligation to guarantee the appropriate inflation rate in order to
- avoid the risk of deflation. When faced with deflation, monetary policy interest rates may not be able to provide enough stimulation to the economy. This makes it harder for monetary policy to fight against deflation than against inflation. It should also be remembered that there may be errors in the measurement of changes in the price level;
- manage the impact of different inflation rates in different countries of the euro area. This helps avoid some countries in the euro area having to cope with inflation that is too low, or even with deflation.