The definition of price stability
The primary objective of the ECB – price stability – is clearly established in the Treaty on the Functioning of the European Union. However, the Treaty does not give a precise definition of what is meant by price stability.
The ECB’s Governing Council adopted a quantitative definition of price stability in 1998:
"Price stability is defined as a year-on-year increase in the Harmonised Index of Consumer Prices (HICP) for the euro area of below 2%."
The Governing Council clarified in 2003 that in the pursuit of price stability it aims to maintain inflation rates below, but close to, 2% over the medium term.
- makes the monetary policy more transparent;
- provides a clear and measurable yardstick against which the European citizens can hold the ECB accountable;
- provides guidance to the public for forming expectations of future price developments.
Focus on the euro area
The ECB’s definition of price stability makes clear that the focus of its monetary policy is on the euro area as a whole. Therefore, price stability is assessed on the basis of price developments in the euro area economy.
By referring to “inflation rates 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.
Reasons for aiming at below, but close to, 2%
Inflation rates of below, but close to, 2% are low enough for the economy to fully reap the benefits of price stability.
It also underlines the ECB’s commitment to:
- provide an adequate margin to avoid the risks of deflation. Having such a safety margin against deflation is important because there are limits to how far interest rates can be cut. In a deflationary environment monetary policy may thus not be able to sufficiently stimulate aggregate demand by using its interest rate instrument. This makes it more difficult for monetary policy to fight deflation than to fight inflation.
- take into account the possibility of HICP inflation slightly overstating true inflation as a result of a small but positive bias in the measurement of price level changes using the HICP.
- provide a sufficient margin to address the implications of inflation differentials in the euro area. It avoids that individual countries in the euro area have to structurally live with too low inflation rates or even deflation.