Inflation, stable prices and interest rates
Consumers and businesses alike must be able to trust that prices will, on average, rise only very gradually if at all – in other words, that inflation is kept under control. Stable prices, or price stability, means that one year from now a euro will buy roughly the same as it buys today. Strongly rising (inflation) or falling (deflation) prices lead to insecurity and will harm the economy. Hence price stability is a necessary precondition for a healthy economy.
Harmful effects of high inflation
Rapidly rising prices erode our purchasing power. People will start demanding higher wages. Companies will, in turn, factor the higher wages into the prices of their products. The result is a spiral with wages and prices pushing each other up and up while interest rates increase as well. In such an environment, where all goods and services keep growing more and more expensive, consumers and businesses are left without solid ground to base sound economic decisions on. Price stability offers them security and confidence, both of which contribute to sustainable economic growth. This is why the policy of the European Central Bank (ECB) is directed at maintaining price stability.
The ECB Governing Council and price stability
As De Nederlandsche Bank participates in the Governing Council of the ECB, it is partly responsible for keeping prices stable throughout the euro area. The ECB Governing Council consists of the central bank governors of the thirteen euro countries plus the ECB Executive Board. As the guardians of price stability they have agreed that prices must be allowed to rise by just under 2% per year.
Interest rate
Although the Governing Council cannot influence price levels directly, it does have a means to control inflation in a roundabout way: the interest rate. The ECB’s primary interest rate serves as the economy’s throttle and brake pedals.
A rate increase will push prices down, or at least rein in rising prices. A rate cut will make prices go up faster. An increased interest rate means that it will cost more to borrow money, and people will have less money left to spend. As a result, the economy will slow down and so will price increases. However, since it may take several months for a rate change to work its way through into prices, the effect is not always clearly visible.
