Keeping prices stable is the primary goal of the European Central Bank (ECB). Stable prices are essential for economic growth and job creation. Prices have risen far too fast for a while, 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. For example Dutch inflation was 1.0% in December 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 was high for a long time. Your daily groceries, going to the hairdresser or a new bike: everything became a lot more expensive in a fairly short time. These price hikes are all related to the Covid-19 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.
Why does inflation need to come down?
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.
ECB steps on the brakes
Although inflation in the Netherlands and the euro area is currently falling rapidly, euro area inflation is still 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 has been exceptionally high for a while. The ECB has been working hard to get inflation down, and the impact of its policy may take some time to materialise. But price increases are not taboo: the inflation rate does not have to drop to 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 over 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 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 interest rate changes. That takes time. A lot also remains uncertain due to global tensions and what they mean for our economy and inflation. The ECB is therefore remaining vigilant, gradually introducing new measures to bring inflation back to 2% and keep it at that level 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 financial supervisory authorities in the European Union have prepared a factsheet with useful tips and suggestions.
As an economist specializing in central banking and monetary policy, I have a deep understanding of the concepts and mechanisms discussed in the provided article. My expertise is grounded in extensive research, academic knowledge, and practical experience in analyzing economic trends, particularly in the context of inflation and the role of central banks.
The article revolves around the European Central Bank's (ECB) efforts to maintain price stability, particularly in the face of inflationary pressures resulting from factors such as the COVID-19 pandemic and the war in Ukraine. Let's delve into the key concepts used in the article:
- Definition: Inflation refers to the sustained increase in the general price level of goods and services in an economy over time.
- Measurement: The inflation rate is expressed as a percentage, indicating the percentage increase in prices over a specific period. In the article, Dutch inflation in December 2022 is cited as an example, with a rate of 1.0%.
Calculation of Inflation Rate:
- Agency Responsible: Statistics Netherlands (CBS) is mentioned as the agency responsible for calculating the inflation rate.
- Methodology: The agency uses a "basket" of various products to track changes in prices, and the inflation rate is calculated monthly. The Harmonised Index of Consumer Prices (HICP) is used as a European standard for cross-country comparisons within the euro area.
Factors Contributing to Inflation:
- COVID-19 and War Impact: The article highlights that inflation has been influenced by the COVID-19 pandemic and the war in Ukraine.
- Supply Chain Disruptions: The pandemic caused disruptions in the supply chain, leading to shortages of products and services. The war in Ukraine further exacerbated these shortages, particularly in gas, oil, and foodstuffs.
Relationship Between Energy Prices and Inflation:
- Expensive Energy: High energy prices are identified as a contributor to overall price increases. Increased costs in energy-intensive processes, such as heating greenhouses and fuel for transportation, result in higher prices for various products.
Role of Central Banks in Managing Inflation:
- Monetary Policy: The article emphasizes that central banks, like the ECB, do not directly set prices but use monetary policy tools to influence inflation indirectly.
- Interest Rates: The key policy rate, which involves setting interest rates for borrowing and depositing money, serves as a tool to control inflation. The article mentions that the ECB raised interest rates multiple times in 2022 to address high inflation.
- ECB's Target: The ECB aims for an inflation rate of 2% across the euro area over the medium term.
- Reasoning: The 2% target is explained as providing a safety margin to avoid deflation, where prices drop. A target below 2% could increase the risk of deflation, which is considered harmful to the economy.
Challenges and Uncertainties:
- Global Tensions: The article acknowledges uncertainties in the economic outlook, including global tensions, and highlights the need for vigilance by the ECB.
- Time Lag in Inflation Response: It is mentioned that inflation does not respond immediately to changes in interest rates, requiring time for the impact of policy measures to materialize.
In conclusion, the article provides a comprehensive overview of the complex factors influencing inflation, the role of the ECB, and the challenges in maintaining price stability in the euro area. It also underscores the importance of striking a balance in inflation targeting to support economic growth and stability.