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Horecamedewerker met dienblad in de hand

Keeping prices stable, in other words, keeping inflation at 2%. That is the target which the European Central Bank (ECB) aims at. While inflation was below that target for a number of years, it has risen sharply during 2021.

Inflation and our prosperity

Inflation means that prices are rising. That means we  can buy less for the same amount of money. Conversely, deflation means that prices go down. Some degree of inflation is beneficial for the economy. If prices rise gradually, this will encourage consumers to spend their money. But excessive of rapid price drops or rises lead to great uncertainty. Central banks want to avoid uncertainty, because it slows down the economy.

2% inflation rate

The European Central Bank (ECB) aims to keep prices stable. This is the best contribution that central banks can make to the prosperity of people in Europe. The ECB defines stable prices as inflation of 2% throughout the euro area in the medium term. That 2% provides a safety margin in the event that prices drop. It reduces the risk that we will end up in a situation of deflation. The ECB wishes to prevent deflation from occurring, because it adversely affects our economy.

ECB does not control inflation

Price increases are very important for setting interest rates. The ECB's Governing Council sets interest rates. It does so on the basis of the outlook for inflation and trends in the economy. Of course, the ECB does not set price levels. That is what the market does: high demand and low supply cause prices to rise. The ECB therefore has no direct control over inflation. But it does have tools to influence inflation indirectly. The most important instrument the ECB has is the interest rate. But it can also organise purchase programmes in exceptional times, with the aim of boosting the economy and promoting inflation.

The ECB's interest rate decisions

Interest rate decisions are taken by the entire Governing Council of the ECB. DNB President Klaas Knot has a seat on the Council, as do the governors of the other euro area central banks and the members of the ECB's Executive Board. In its decisions, the Governing Council considers implications for all countries that use the euro as their currency. This means that its members take into account not just the interests of their home countries, but also of the other euro area countries in the euro area. ECB President Christine Lagarde chairs the Governing Council.

Interest rates up or down

In short, the interest rates act as the accelerator and brake of the economy, as follows.

  • Lowering interest rates
    A cut in interest rates aims to stimulate the economy and thereby drive up inflation. So how does that work? When interest rates are low, borrowing is much cheaper as interest payments are lower. In practice, low interest rates often mean that people and businesses can borrow and spend more easily, but are less likely to put their money in a savings account because it earns them less interest. And if people and businesses can spend more money, demand increases. And if demand rises, prices go up.
  • Increasing interest rates
    An increase in interest rates aims to slow the economy down slightly to ensure that inflation is not so high. So how does that work? Higher interest rates make it more expensive to borrow money. As a result, people and businesses spend less money. As a result, demand will fall. Prices will rise less sharply, which in turn will depress inflation.

Are interest rates increased if inflation goes up?

Prices may rise temporarily. For example, if it freezes in Brazil, the coffee prices will go up. And there are many more developments that affect prices. Tensions between oil-producing countries, for example, may push up petrol prices. While this type of price increases may be a cause of concern, they are temporary. So they do not automatically prompt the ECB to intervene immediately and raise interest rates. After all, the ECB has set its inflation target for the medium term.

High inflation: temporary or permanent?

Inflation has risen sharply in recent months. It is now above the ECB’s 2% target. This is mainly due to higher energy prices and disruptions in the supply of products during the coronavirus crisis, which has caused all sorts of shortages. So demand is now higher than supply, causing many prices to rise. The ECB expects this higher inflation rate to be temporary, as these shortages will be eliminated in due course. So the balance between supply and demand will then be restored. Current expectations are that inflation will fall back below the 2% target. This is why the ECB does not adjust its policy immediately. It does keep an eye, however, on whether high inflation persists for longer than expected. If high inflation persists for a long time, the ECB may in the future raise interest rates and reduce its purchase programmes where necessary to ensure price stability.

Measuring inflation

The ECB looks at inflation trends in all euro area countries when making interest rate decisions. Price increases or decreases are measured on the basis of a basket with a wide range of consumer products that we spend our money on –  from coffee to clothing and from a smartphone subscription to the rent of a home. This basket is referred to as the Harmonised Index of Consumer Prices (HICP). The ECB will also include home-ownership costs in this basket.

Interest rates have been low for years

Interest rates in the euro area have been falling for a long time. Read more about low interest rates  and how they affect us in our daily lives. Or read more about the ECB’s interest rate policy.