The ECB’s Governing Council has defined price stability as an inflation rate of below but close to 2% over the medium term. This aims to avoid situations of prolonged deflation (i.e. a broad-based decline in prices) or inflation above the inflation rates defined by the Governing Council of the ECB as compatible with price stability. There are several benefits of price stability:
- Improving the transparency of the price-setting mechanism. Under price stability people can more easily recognise changes in relative prices (i.e. price changes between different goods or services), since they are not obscured by fluctuations in the overall price level. As a result, companies and consumers can make better informed decisions contributing to a more efficient allocation of resources, which in turn increases household welfare and the productive potential of the economy;
- Reducing “inflation risk premia” in interest rates (i.e. compensation creditors ask for the risks associated with holding nominal assets, which are not indexed to the inflation rate), which contributes to reducing the real interest rates;
- Reducing the probability of households and companies diverting resources from productive uses in order to hedge against inflation, which hampers economic growth. For example, in a high inflation environment there is an incentive to stockpile real goods since they retain their value better than money or some financial assets in such circumstances;
- Reducing distortions caused by the impact of inflation or deflation on tax and social security systems, since the latter do not normally allow for the indexation of tax rates and social security contributions to the inflation rate;
- Preventing an arbitrary redistribution of wealth and income as a result of unexpected inflation or deflation (e.g. redistribution effects from creditors to debtors).
All these arguments, supported by empirical evidence, suggest that a central bank that maintains price stability makes a substantial contribution to the achievement of broader economic goals, such as higher standards of living, high levels of economic activity and better employment prospects.