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Keeping prices stable is the primary goal of the European Central Bank (ECB). Stable prices are essential for economic growth and job creation. Prices are rising far too fast these days, and the central bank is taking measures to bring inflation back down.
Inflation: price increases
When the prices of many goods and services increase, we call this inflation. Inflation is expressed as a percentage. Dutch inflation was 16.8% in October 2022. That percentage indicates how much more money consumers spent on average on day-to-day expenses compared to a year earlier.
How the inflation rate is calculated
Statistics Netherlands (CBS) is the agency that calculates the rate of inflation. They do so by tracking prices in a "basket" of all kinds of products we spend money on, from coffee to clothes, from smartphone plans to housing costs. Statistics Netherlands calculates the current inflation rate every month, making use of a European standard so that inflation can be compared throughout the euro area. This is known as the Harmonised Index of Consumer Prices (HICP).
COVID-19 and war boost inflation
Inflation is high these days. Your energy bill, daily groceries or a new bike: everything costs a lot more than a year ago. These price hikes are all related to the coronavirus pandemic and the war in Ukraine.
The economy came to a standstill in 2020 as a result of the pandemic. When the economy rebounded and demand for all kinds of products and services increased, companies could not get materials and people fast enough to supply them. This created huge shortages of products and services. The war in Ukraine caused further shortages, especially of gas and oil, along with shortages of foodstuffs such as grain and sunflower oil.
In the wake of the pandemic and the war, demand for many goods and services outstripped supply. And when demand exceeds supply, prices rise. That is simply how the market works.
Expensive energy boosts prices further
High energy prices make other products more expensive, too: the greenhouses where your peppers and tomatoes grow need to be heated. The van that delivers your order to your door needs fuel to run. And with all the price hikes making life more expensive, many workers also want higher wages. Higher wages mean higher costs for employers, and these are also reflected in prices.
Inflation and our prosperity
Inflation means that most prices are rising. And when inflation is high, you really start to notice everything becoming more expensive. This means you cannot buy as much with your money. Maybe you are no longer able to make ends meet on your income. That's not good for you, and it's not good for the economy either. When inflation is too high, prices change rapidly and uncertainty grows. This puts a brake on the economy, and that's what central banks want to avoid.
Central banks and inflation
Of course, the European Central Bank (ECB) does not set prices. The market sets prices according to the law of supply and demand. The ECB has no direct control over inflation, but it does have tools to influence inflation indirectly. It does so with monetary policy.
Interest rate as accelerator and brake pedal
The main tool the ECB is currently using to bring down inflation is the key policy rate, which is the interest rate at which banks borrow money from the ECB or deposit money with the ECB. In short, the interest rate acts as the accelerator and brake pedal for the economy as follows.
- Lower interest rates
Lower interest rates help to stimulate the economy, which then drives up inflation. How? When interest rates are low, it is cheaper to borrow money as interest payments are lower. In practice, low interest rates often mean that people and businesses find it easier to borrow and spend more. They are less likely to put their money in a savings account because they won't earn much interest. And if people spend more and businesses invest more, demand increases. If demand rises, prices rise too. In other words, inflation increases.
- Higher interest rates
Higher interest rates slow the economy down which then brings inflation down. How? Higher interest rates make it more expensive to borrow money, while also making it more interesting to save money. As a result, people and businesses spend less money and demand drops. Prices then rise less sharply, which in turn brings inflation down.
ECB steps on the brakes
Eurozone inflation is too high. Our inflation target is 2%. Central banks are using higher interest rates to try to reduce demand for goods and services in order to bring inflation back down. The ECB raised policy rates three times in 2022, and it has continued to do so in 2023, lifting the deposit facility rate to 4% in September.
Inflation is not always a bad thing
Today's economic circumstances are exceptional and current inflation is unusually high. The ECB is working hard to bring inflation back down. But price increases are not taboo: the inflation rate does not have to reach 0%. Some degree of inflation is in fact good for the economy. Gradually rising prices actually encourage consumers to spend their money.
The target is 2%
The ECB sees ensuring stable prices as the very best thing central banks can do for the prosperity of people in Europe. This means an inflation rate of 2% across the euro area in the medium term. Price trends are then clear and predictable for everyone.
0% is too little...
Why isn't the ECB's target 0% or 1%? The 2% target provides a safety margin in the event that prices drop. It reduces the risk that we will end up in a period of deflation, which is a drop in the general level of prices. This is something the ECB wants to avoid because it can cause damage to our economy. People and businesses then wait to make their purchases or investments in the hope that everything will become even cheaper. Demand then falls, and the economy may even grind to a halt.
...and 4% is too much
The 2% target is not arbitrary. Inflation that is any higher is not beneficial for the economy. Research by DNB experts has found that inflation that remains above 4% for a long time is bad for economic growth.
So? What can we expect inflation to do now?
The ECB has already intervened firmly in 2022 with a series of interest rate hikes to eventually bring high inflation down to lower levels. Inflation never responds immediately to higher interest rates. That takes time. Moreover, the war in Ukraine continues and its impact on the supply of gas and oil to Europe is uncertain. The ECB is therefore remaining vigilant, gradually introducing new measures to bring inflation back to 2% over the medium term.
European supervisory authorities provide tips and suggestions
The cost of living has shot up and interest rates are also a lot higher than they were in recent years. Higher interest rates affect the repayment of mortgage loans and personal loans, and the value of pensions. It is not always clear how to deal with the various impacts in the best possible way. That is why the three financial supervisory authorities in the European Union have prepared a factsheet with useful tips and suggestions.
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