Price stability can be defined as a state where changes in the general level of prices need not be factored into consumption and investment decisions. In an environment of price stability, inflation is moderate and predictable. The best way for Eurosystem monetary policy to promote a favourable economic environment and high employment is by ensuring 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 that results in a decrease in the value of money, i.e. a decline in purchasing power. Deflation is often defined as the opposite to inflation, in other words a situation where the general level of prices continuously falls.
Rapid inflation is harmful in many ways. A change in the inflation rate weakens the information conveyed by prices, which may distort economic decisions and thereby undermine economic growth. Unstable price developments also create injustice, since they randomly change the value of monetary assets and therefore hurt the position of retail savers in particular. Uncertainty about inflation developments may also result in an increase in risk premia, slowing economic growth.
Deflation is considered even more dangerous as a phenomenon than inflation. It means a general decline in wages and prices, while the value of money increases. During periods of deflation, loans are repaid with money that is worth more than when the loan was taken out, and hence deflation has often given rise to debt crises and an increase in bankruptcies.
Fluctuations in inflation and uncertainty relating thereto tend to rise in line with the average rate of inflation. Therefore, the price stability target is often set as close to zero as possible. On the other hand, there are also risks related to very low inflation. It is often difficult to cut nominal prices and wages. As a consequence, a predictable and sluggish rate of inflation cushions changes in relative prices, which contributes to balanced economic developments. The most commonly used inflation indicators have also been found to involve measurement bias.
In the euro area, price stability is defined as a year-on-year increase of below, but close to, 2% in the Harmonised Index of Consumer Prices (HICP) for the euro area, to be maintained over the medium term. The ECB Governing Council has stated that it targets inflation close to the upper boundary of the definition of price stability in the medium term. This target provides a buffer against deflation and reduces the probability of a situation where the central bank can no longer boost inflation by lowering its policy rate.