Price stability

Rapid inflation and deflation are economic phenomena that have adverse impacts on the economy. Inflation is defined as a general increase in the prices of goods and services. It leads to a reduction in the value of money and its purchasing power. The opposite of inflation is deflation, a situation where the general level of prices continuously falls for a longer period and the value of money increases. 

Rapid inflation is harmful in many ways. Changes in inflation weaken the information conveyed by prices as the prices of goods and services rise rapidly and at different paces and the relative prices change in a way that is difficult to predict. This may distort economic decisions and undermine economic growth. When inflation picks up, economic uncertainty increases.

An unstable upward trend in prices can also have an undesirable impact on the distribution of income and wealth, since it randomly erodes the value of income and savings. A higher than expected inflation is detrimental to the position of savers, in particular, as it erodes the purchasing power of savings.

Deflation is an even greater hazard than inflation

Deflation is considered an even greater hazard than inflation. If households and businesses begin to expect a prolonged fall in prices, this will trigger a self-reinforcing spiral in which consumption and investment are postponed and aggregate demand in the economy weakens sharply. As a result, prices will fall even further. During a period of deflation, loans must be repaid with money that is worth more than when the loan was taken out, and hence periods of deflation have often given rise to debt crises and an increase in unemployment and bankruptcies.

Predictable and sufficiently low of inflation reduces uncertainty

For these reasons, central banks usually set their inflation target at 2%. Predictable and sufficiently low inflation serves to reduce economic uncertainty and facilitates the monitoring of changes in relative prices. Moderate but above-zero inflation provides a safety margin against the risk of deflation and allows for changes in relative prices because prices and wages are typically rigid in the downward direction. It also creates monetary policy space for interest rate cuts if the cyclical conditions deteriorate. The most commonly used inflation indicators have also been found to involve upward measurement bias, meaning that the actual level of inflation may be lower than the measured level.

In the euro area, price stability is best maintained by aiming for a 2% inflation target over the medium term.

The ECB’s Governing Council considers that price stability in the euro area is best maintained by aiming for 2% inflation in the euro area economy over the medium term. According to the ECB’s monetary policy strategy, the Harmonised Index of Consumer Prices (HICP) is the appropriate measure for assessing the achievement of the price stability objective.

The ECB’s monetary policy has a medium-term orientation. This allows for inevitable short-term deviations of inflation from the target, as well as lags and uncertainty in the transmission of monetary policy to the economy and to inflation. The flexibility of the medium-term orientation takes into account that the appropriate monetary policy response to a deviation of inflation from the target is context-specific and depends on the origin, magnitude and persistence of the deviation. The 2% inflation target is symmetric, meaning that both positive and negative deviations from the target over the medium term are equally undesirable.