What is inflation and why a 2% target?
What is inflation?
Inflation refers to the change in the prices of goods (such as clothing or electricity) and services (such as haircuts or air travel) consumed by households over time.
We say there is inflation when the prices of many of the goods and services we buy increase at the same time and in a continuous way. In other words, inflation is a broad-based increase in prices over time.
How is it measured?
Inflation is usually measured by comparing the prices of goods and services today with the prices a year ago. If the inflation rate is 1%, this means prices in general are 1% higher than a year ago, i.e. a shopping basket that cost €100 a year ago would now cost €101.
In practice, the inflation rate is measured as the percentage change in a price index. A price index is just a weighted average of a broad set of prices. The prices of hundreds of individual goods and services are combined according to their importance in household spending.
In the euro area, the main price index is called “Harmonised Index of Consumer Prices” (HICP). This is the index used by the ECB to assess price stability.
The ECB would like to use an inflation measure that reflects people’s cost of living even better. This is why it would like the HICP to include costs related to owner-occupied housing and not just rents. However, this is difficult and it will take some time to achieve this goal.
Why a 2% inflation target over the medium term?
Price stability means avoiding prolonged periods of inflation that is either too high or too low. The ECB therefore aims to achieve an inflation rate of 2% over the medium term.
The ECB considers that 2% provides a safety margin against deflation and enough flexibility to reduce interest rates in adverse situations.
The medium-term perspective means that the ECB looks at the inflation rate over time rather than focusing on short-term fluctuations. In fact, it would be impossible to keep inflation at 2% all the time and it is not even desirable for the central bank to attempt do so. Being guided by the medium term also enables the ECB to address other concerns when deciding on monetary policy.
This 2% inflation target over the medium term is symmetric. This means that the ECB considers inflation below the target to be just as undesirable as inflation above the target.
Why should we care about inflation?
Inflation affects us all.
It is difficult to imagine a day when we do not spend money. In addition, money only retains its value over time if prices do not increase a lot.
If prices increase a lot and in an unpredictable way, everyone must spend more time and resources tracking and trying to forecast inflation, as well as planning and taking steps to protect themselves against the effects of inflation.
What would you do if the money you have in your bank account were to buy much less every year?
- Would you spend more time thinking about how to make the most of it?
- Would you change what you buy or how much you buy?
- Would you keep your money in a savings account?
The ECB sets monetary policy to ensure that inflation remains low and stable in the euro area and is not a major concern for citizens.