Bank of Lithuania

Together with the European Central Bank (ECB) and other euro area central banks, we work towards achieving the primary objective of the single monetary policy – maintaining price stability in the euro area. Price stability is defined as inflation below, but close to, 2 per cent over the medium term. Stable prices contribute to sustainable economic growth and the improvement of resident welfare.

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Why is price stability important?

The primary objective of the Eurosystem – maintaining price stability within the euro area – is established in Article 127(1) of the Treaty on the Functioning of the European Union. Maintaining price stability is crucial – it allows ensuring stable and sustainable economic growth, a high employment rate and increase in economic welfare. The Eurosystem also takes into account the broader economic goals of the euro area, namely full employment as well as stable and sustainable economic growth, but only with the overriding importance assigned to price stability.

Price stability, first and foremost, implies avoiding an extended period of deflation or excessive inflation, since both have a negative effect on economic development. In pursuing price stability, we not only monitor the current level of inflation, but also aim to anchor inflation expectations at a target level. We manage inflation by setting an appropriate measure of inflation and a clear monetary policy strategy, as well as communicating it to the public.

Excessive inflation devalues money, slows down economy or even paralyses it, while deflation is even more dangerous as it may lead to a self-reinforcing economic downturn. Moderate and stable inflation is beneficial in terms of economic growth and the increase of public welfare.


Why excessive inflation or deflation is damaging?

Excessive inflation makes businesses orient towards short-term goals, while elevated uncertainty increases interest rates and hinders long-term investment. In addition, it becomes increasingly more difficult to compare relative prices, thus economic resources get allocated irrationally, and more time gets wasted for unproductive activities to frequently review prices and hedge against inflation.

Deflation – an extended period of price declines – is even more harmful than excessive inflation, as it creates a spiral of negative effects: it becomes more difficult for businesses to sell goods or services, cover costs and repay debts; banks limit lending as the situation of debtors deteriorates; expectations of enterprises and consumers crumble, hence investment and spending are cut – all this weighs even more on solvent demand, prices, lending and investment. Bank stability comes under threat as depositors withdraw their savings and debtors can no longer pay their liabilities back.

Taking this into account, the Governing Council of the ECB has established a price stability objective within the Eurosystem – inflation rates of below, but close to, 2 per cent.

ECB: Measuring inflation – HICP


Why 2 per cent?

The Governing Council of the ECB has defined price stability as a year-on-year increase in the Harmonised Index of Consumer Prices (HICP) within the euro area of below, but close to, 2 per cent over the medium term. In this context, the medium term orientation stands for such a period of time, during which the effect of monetary policy on economy and price level is fully-fledged. It may last 2–5 years, since monetary policy instruments affect prices and economy through different channels, spanning different periods of time. This definition provides a clear indicator against which the public may form its expectations for price developments.

Inflation rates below, but close to, 2 per cent are sought by the Eurosystem for several reasons:

  • such inflation is too low to damage economy, yet it gives the Eurosystem room to safeguard the euro area against deflation;
  • interest rates, consisting of real interest rates and the projected inflation, are somewhat higher compared to a situation when expected inflation is at zero. Hence, in case of economic downturn, the Eurosystem has more room to boost inflation in a traditional manner, i.e. by reducing interest rates;
  • inflation across individual euro area countries is and will be different, thus the aim to maintain inflation rates below, but close to, 2 per cent mitigates the risk of deflation in some countries;
  • research shows that, due to imperfect measurement of the quality of goods, the calculated developments of price level may be somewhat larger than they actually are, hence the inflation target provides sufficient margin to address such overvaluations.
     

The benefits of price stability to economic activity and the level of employment:

  • transparency of price setting improves, as people can differentiate changes in relative prices from changes in the overall price level. This allows them to make optimal consumption and investment decisions;
  • inflation risk premia in interest rates, i.e. compensation creditors ask for risks associated with inflation, decrease. This reduces interest rates;
  • unproductive activities to hedge against the negative impact of excessive inflation or deflation are avoided;
  • distortions of excessive inflation or deflation get averted, especially for tax and social security systems;
  • arbitrary redistribution of wealth and income as a result of unexpected excessive inflation or deflation is avoided;
  • financial stability improves (as price stability is a precondition for financial stability).

ECB: Benefits of price stability

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Last update: 21-04-2017