The Eurosystem’s Definition of Price Stability

Obtaining price stability and assessing whether or not it has been achieved requires a clear definition of the price stability objective. In recognition of this fact, the Governing Council of the ECB has identified a specific measure of inflation that is to serve as a yardstick and has established a target rate,  defining price stability as a year-on-year increase in the Harmonised Index of Consumer Prices (HICP) for the euro area of below but close to 2%. Therefore, both an inflation rate of more than 2% and a decline in the general price level (deflation) are considered outside the price stability definition.  Furthermore, the Governing Council has stated that price stability does not have to be achieved on a monthly but on a medium-term basis.   Consequently, short-term deviations from the defined range will not automatically prompt the ECB to change interest rates.  The Harmonised Index of Consumer Prices for the euro area is a weighted average of the national consumer price indices, which are calculated using a harmonized method for the euro area countries. 

To specify the price stability objective, the Governing Council of the ECB announced the following quantitative definition in 1998:  “Price stability shall be defined as a year-on-year increase in the HICP for the euro area of below but close to 2%. Price stability is to be maintained over the medium term 

The Governing Council publicly announced its quantitative definition of price stability for several reasons.  First, by clarifying how the Governing Council interprets the goal it has been assigned by the Treaty, the definition helps to make the monetary policy framework easier to understand (i. e. it makes monetary policy more transparent).  Second, the definition of price stability provides a clear and measurable yardstick against which the public can hold the ECB accountable. Deviations of price developments from the definition of price stability can be identified, and the Eurosystem would then be required to provide an explanation for such deviations and to explain how it intends to reestablish price stability within an acceptable period of time. Finally, the definition provides guidance to the public for forming expectations of future price developments. 

The definition of price stability makes clear that the Eurosystem has a euro area-wide mandate.  Accordingly, price stability is assessed on the basis of price developments in the euro area viewed as a whole, indicating that decisions regarding the single monetary policy aim at achieving price stability in the euro area as a whole. This focus on the euro area as a whole is the natural consequence of the fact that, within a monetary union, monetary policy can only steer the average money market interest rate level in the area, i. e. it must use a tool that is uniform across the area.

The definition also identifies a specific price index – namely the HICP for the euro area – as the one to be used for assessing whether price stability has been achieved.  This index has been harmonized across the various countries of the euro area.  The HICP is the index that most closely approximates the changes over time in the price of a representative basket of consumer spending. The use of a harmonized index makes transparent the Eurosystem’s commitment to the full and effective protection against losses in the purchasing power of money.

By referring to “an increase in the HICP of below but close to 2%” the definition makes clear that not only inflation above 2% but also deflation (i. e. price level declines) is inconsistent with price stability. In this respect, the explicit indication by the Eurosystem to aim to maintain the inflation rate at a level close to the upper boundary of the definition it signals its commitment to provide an adequate margin to avoid the risks of deflation.

While deflation implies similar costs to the economy as inflation, avoiding deflation is also important because, once it occurs, it may become entrenched as a result of the fact that nominal interest rates cannot fall below zero.  In a deflationary environment monetary policy may thus not be able to sufficiently stimulate aggregate demand by using its interest rate instrument.  Any attempt to bring the nominal interest rate below zero would fail, as the public would prefer to hold cash rather than to lend or hold deposits at a negative rate.   Although various monetary policy actions are possible even when nominal interest rates are at zero, the effectiveness of these alternative policies is not certain. This makes it more difficult for monetary policy to fight deflation than to fight inflation.

By setting the upper bound for inflation clearly above zero and aiming at inflation below but close to 2%, the ECB also takes into account the possibility of HICP inflation as a result of a small but positive bias in the measurement of price level changes using the HICP. For various reasons, consumer price indices may be subject to measurement errors.  Such errors may arise if prices are not adequately adjusted for changes in quality or if some relevant transactions remain systematically out of the sample used to construct the index.

In the past, a number of economic studies have identified a small but positive bias in the measurement of national consumer price indices, suggesting that (as a result of quality improvements in goods, for example) a measured inflation rate of zero could in fact imply a slight decline in the actual price level. Where the euro area is concerned, evidence of a measurement bias in the HICP remains scarce, reflecting its short history. However, some studies indicate that the size of the bias is likely to be limited, even if the level of uncertainty that surrounds these estimates is still very high. In addition, taking into account the continuous improvements being made to the HICP’s properties by Eurostat (the European Commission agency responsible for statistics), any bias is likely to further decline in the future.

Monetary policy can only influence the price level of the euro area as a whole and cannot take into account inflation differentials across regions or cities.  In principle, inflation differentials across regions are a normal feature of any monetary union. They are an integral part of the adjustment mechanism resulting from divergences in economic developments across regions.  Inflation differentials may reflect transitory factors and may be only temporary. Such differentials are of little economic concern.  However, if there are structural inflation differences in the euro area, this could create economic problems in countries or regions with below-average inflation, for instance if economies are affected by downward nominal rigidities – i.e. the difficulty or impossibility of implementing cuts in wages and prices – which could prevent or hamper the necessary adjustments in relative prices. According to all available studies, a rate of inflation below but close to 2% for the euro area also provides a sufficient margin in this respect.

Finally, a fundamental aspect of the Eurosystem’s monetary policy is that it aims to pursue price stability “over the medium term.” As outlined above, this reflects the consensus that monetary policy cannot fine-tune developments in prices or inflation over short horizons of a few weeks or months. Changes in monetary policy only affect prices with a time lag, and the magnitude of the eventual impact is uncertain. This implies that monetary policy cannot offset all unanticipated disturbances to the price level. Some short-term volatility in inflation is therefore inevitable.