The general public may associate price stability with a flat price level, but central banks generally aim for a rate of inflation of around 2%. The table below provides an overview for several central banks.
Table: Price stability targets of major central banks in 2016
|Canada||The Bank of Canada aims to keep inflation at the 2% midpoint of a target range of 1-3%.||Year-on-year rate of change in the consumer price index (CPI)|
|Euro area||The ECB seeks to keep inflation below, but close to, 2% over the medium term.||Year-on-year change in the Harmonised Index of Consumer Prices (HICP) for the euro area|
|Japan||The Bank of Japan uses a price stability target of 2% inflation||Year-on-year rate of change in the CPI|
|United Kingdom||De Bank of England's operational objective for monetary policy is an inflation rate of 2%.||Rate of change in the CPI over the past 12 months|
|United States||The Federal Reserve aims for 2% inflation over the medium term.||Annual change in the price index for personal consumption expenditures (PCE)|
|Sweden||The Riksbank's inflation target is around 2% per year.||Annual rise in the CPICPI|
|Switserland||De Swiss National Bank defines price stability as an increase in the CPI of less than 2% per year.||Annual increase in the CPI|
Errors of measurement
Central banks have various reasons for not pursuing a 0% rate of inflation. A moderately positive inflation target serves as a buffer against falling prices in the event of measurement errors in the official inflation figures. Inflation is typically measured by comparing the current price of a basket of goods and services consumed with the price of that same basket in a given base year. Measuring inflation is no easy task, however, as inflation can be overestimated due to a range of factors. Firstly, quality improvements may cause price changes to be overestimated. If the price of a good remains the same while its quality has improved, the buyer will get a better product at the same price. This means the product has become cheaper assuming equal quality. Statistics offices try to factor in such adjustments for quality improvement in calculating price indices. However, if they underestimate those quality improvements, they overestimate inflation.
Secondly, new goods rapidly become cheaper in the first few years after their introduction, but it can take several years before they are included in the basket of goods used to calculate inflation. This means their price decrease is not reflected in the rate of inflation. Similarly, shifts in market shares between retailers that are not reflected in the composition of the sample used, for example a shift towards discount stores, may cause distortion.
Buffer against self-reinforcing price drops
A limited rate of inflation may also be desirable to counteract widespread, self-reinforcing price drops accompanied by a sharply contracting economy and postponed spending. Protracted periods of price slides are highly damaging to the economy. If debtors are unable to meet their commitments, they will be forced to sell assets, which may further depress prices. This will create a vicious circle of rising real debts and financial distress.
Smoother functioning economy
Furthermore, moderate inflation helps the labour market adjust smoothly should the economy falter. After all, it is difficult to adjust nominal wages downwards.If inflation is virtually 0%, employers will find it hard, if not impossible, to reduce their employees' wages in a situation of downward nominal wage rigidity. They will then have to fall back on dismissals to cut costs, which will push up the unemployment rate. By contrast, in a moderate inflation environment, businesses have the option of reducing real wages by ensuring that nominal wages do not go up in line with inflation.
Low interest rates
Finally, if inflation is extremely low, nominal interest rates will also be close to zero. In such a situation, a central bank will not have many options for easing monetary policy if the economy is sluggish. Once the monetary policy interest rate reaches the effective lower bound, conventional monetary policy ceases to work and central banks must resort to different measures.