Price stability can be defined as a situation where there is no need for consumption and investment decisions to take into account changes in the general level of prices. Where there is price stability, inflation is moderate and predictable. Ensuring price stability is the best way for Eurosystem monetary policy to promote a favourable economic environment and high employment.
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 typically defined as the opposite of inflation, in other words a situation where there is a continuous fall in the general level of prices.
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. An unstable upward trend in prices also creates injustices, since it randomly erodes the value of savings and is therefore detrimental to the position of retail savers, in particular. Uncertainty about inflation may also result in more risk premiums, pushing up interest rates.
Deflation is considered an even greater hazard than inflation. It results in a downward spiral of prices and wages while the value of money goes up. During a period of deflation, loans must be 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 over inflation tend to rise in line with increases in the average inflation. Therefore, the price stability objective is often set as close to zero as possible. However, there are also risks associated with a very low rate of inflation. Nominal prices and wages are inflexible and therefore often difficult to cut. Consequently, a predictable, low rate of inflation serves to mitigate relative price changes that are important for the balanced development of the economy. The most commonly used inflation indicators have also been found to involve upward measurement bias.
In the euro area, price stability is best maintained by aiming for a 2% inflation target over the medium term. The inflation indicator best suited for assessing the achievement of the price stability objective is the Harmonised Index of Consumer Prices (HICP). The ECB Governing Council has launched a multi-year project to incorporate costs related to owner-occupied housing into the HICP index, which would better reflect the rate of inflation important to households. In its monetary policy assessments, the Governing Council is already now taking into account inflation measures that include initial estimates of the cost of owner-occupied housing in its wider set of supplementary inflation indicators.
The ECB’s monetary policy strategy 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.
An inflation buffer above 0% provides monetary policy with space for interest rate cuts in the event of adverse developments and a safety margin against the risk of deflation through its positive impact on the trend level of nominal interest rates.
To maintain the symmetry of its inflation target, the Governing Council recognises the importance of taking into account the implications of the effective lower bound. When the economy is close to the lower bound, this requires especially forceful or persistent monetary policy measures to avoid negative deviations from the inflation target becoming entrenched. Inflation may also be moderately above the 2% target for a transitory period.