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. Strongly rising prices (inflation) or falling prices (deflation) cause insecurity and harm the economy. Hence, price stability is a necessary precondition for a healthy economy. The European Central Bank (ECB) is therefore committed to achieving and maintaining price stability.
The effects of high inflation
Rapidly rising prices erode purchasing power. People start to demand higher wages and companies, in turn, factor these higher wages into the prices of their products. The result is a spiral, with wages and prices pushing each other ever upwards while interest rates increase. In such an environment, where all goods and services keep growing increasingly expensive, consumers and businesses are left without solid ground on which to base sound economic decisions. Price stability offers them security and confidence, both of which contribute to sustainable economic growth.
Definition of price stability
Price stability has been defined as inflation below but close to 2%. Monetary decisions are made by the ECB Governing Council, which consists of the central bank governors of the sixteen euro countries plus the ECB Executive Board.
Although the ECB cannot influence price levels directly, it does have a means to control inflation in a roundabout way: interest rates. Interest rates serve as the economy’s accelerator 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.
Increased interest rates means that it will cost more to borrow money, and people will have less money to spend. As a result, the economy will slow down and so will price increases. Note that it will typically take several months for a rate change to work its way through into prices.