The ECB has defined price stability as a year-on-year increase in the Harmonised Index of Consumer Prices (inflation) for the euro area that is below but close to 2% over the medium term.
Both high inflation and prolonged deflation have a negative effect on economic development and through that also on the welfare of each inhabitant.
High inflation exerts a negative effect on the economy in several ways. It undermines the economic decision-making process and dampens economic growth. Moreover, inflation is unfair as it diminishes the value of savings, particularly affecting the position of retail depositors.
Prolonged deflation is as harmful as high inflation. It results in prices spiralling downward, while the value of money increases. In periods of deflation, loans have to be repaid using money which is more worth than at the time of taking the loan: this causes a debt crisis and an increase in the number of bankruptcy cases.
Therefore, an adequate monetary policy supporting price stability helps to increase the welfare of the population of a single state or a union of states.
The price stability objective means that the central bank needs both monitor the current level of inflation as well as firmly anchor the inflation expectations at a low level. The most effective way for a central bank to anchor the inflation expectations is to set a measurable target and a clear monetary policy strategy, thereby informing the general public beforehand of the economic indicators targeted by the national central bank and the planned steps to achieve its objectives.
In the euro area, price stability is supported through the implementation of the Eurosystem's monetary policy. It affects the economy in several ways, yet the most important is the pass-through of the monetary policy decisions to the short-term money market interest rates. Monetary policy operations have an effect on the free liquidity of the banking system and short-term money market rates, which consequently affects the bank lending and deposit rates and long-term market rates. By steering the interest rates, the monetary policy influences the spending decisions of businesses and households, monetary and financial developments as well as inflation expectations, prices and other macroeconomic fundamentals via various transmission channels.
Harmonised Consumer Price Index