The importance of maintaining price stability

To both households and the economy, it is important that prices are stable:

If inflation is high and unstable, money loses its purchasing power, and the amount of goods and services that you can buy with the same income decreases rapidly, making it hard for households and firms to plan their expenses. Such instability about the future undermines investment and economic growth;
If there is deflation (i.e. a broad-based and continuous decline in prices), people may want to postpone their expenses, waiting for lower prices in the future. If everyone postpones their expenses, firms may have to slow down production and some may file for bankruptcy or be forced to dismiss workers. This would give rise to an increase in unemployment and a slowdown in economic growth.

Conversely, if prices are stable, the value of money remains practically the same over time. This means that:

With a certain amount in euros, people can buy more or less the same amount of goods and services today and in the future;
It is possible to better plan for the future and make appropriate decisions on what to consume, save and invest, without fear of losing purchasing power.

Price stability is important to make financial decisions easier for households and firms, promoting favourable conditions for investment and economic growth.

For this reason, price stability is the main objective of the European Central Bank’s (ECB) monetary policy.

How does the ECB define price stability?

The ECB aims to achieve an inflation rate of 2% over the medium term. This is the target decided upon to maintain price stability in the euro area, seeking to avoid prolonged periods of inflation that is too high or too low. Inflation below the 2% target is as undesirable to the ECB as inflation above target.

To assess price stability, the ECB uses the Harmonised Index of Consumer Prices (HICP). The HICP follows an identical methodology in all European Union countries. In Portugal, it is calculated similarly to the Consumer Price Index (CPI) and considers a basket that is representative of the consumption of households in the Portuguese territory, including spending of non-residents (such as tourists).

How does the ECB influence price developments?

The ECB does not influence the prices of goods and services directly. It makes use of monetary policy instruments (for example, official interest rates) to, indirectly, influence household and corporate spending and thereby the prices of goods and services. It may take several quarters until a monetary policy decision is fully reflected in prices.

How do official ECB interest rates affect interest rates in the economy?

The official interest rates are the main instrument the ECB has at its disposal to fulfil its mission of safeguarding price stability.

The official interest rates are:

the interest rates banks pay for borrowing from the ECB;
the interest rate the ECB pays for the deposits it receives from banks.

When the ECB raises or lowers the official interest rates, the following are affected: (i) the costs of banks with the loans obtained from the central bank, as well as (ii) the value banks receive for their deposits with the central bank. Indirectly, these changes are reflected in the Euribor (European Interbank Offered Rate) rates, which are based on the average of interest rates charged for interbank loans in euro by a group of European banks, as well as in the interest rates banks charge for credit granted to customers and the interest rates they pay for their customers’ deposits.

If the ECB judges inflation to be too low, it may lower the official interest rates to induce a reduction in the economy’s interest rates with the aim of stimulating consumption and investment and raise inflation. Conversely, if the ECB wants to reduce inflation, it may increase the official interest rates, in order to decelerate consumption and investment.

Interest rates charged by banks when granting credit to their customers are not set by the ECB. Nevertheless, by setting official interest rates, the ECB seeks to influence the other interest rates in the economy, namely interest rates applied to home loans, consumer credit or loans to firms charged by banks.

In Portugal, the most used interest rates in loans to households and firms use the Euribor rates as reference and these have different maturities (for example, 3, 6 and 12-month Euribor rates).

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The importance of maintaining price stability

How does the ECB define price stability?

How does the ECB influence price developments?

How do official ECB interest rates affect interest rates in the economy?