Inflation, deflation related to economic growth
Source: Eurostat. Data prior to 1996 are estimated on the basis of non-harmonised national Consumer Price Indices
Amongst many definitions for economics, my preferred definition is this one by Todd Bucholz, in: «An introduction to modern economic thought”, Plume, 1989, “Economics is the study of choice. It does not tell us what to
choose. It only helps us understand the consequences of our choices.” and I might add of our decisions and their consequences”. This brought me to study and teach “Decision Making” by Daniel Kahneman, “Thinking fast and slow”, Allen Lane, 2011. People make decisions, in whatever position they are, on intuition – system 1- or after analysis -system 2. The key issue is the expectation or the vision of what is in front of the decision maker, allowing for a prudent, or not, extrapolation. Key decisions are based on what we have retained from the past, and this is usual very little, how we see the present, this is usual fragmental and what we expect in the very near future.
Economic policy is about analysing and influencing decision making by the economic agents, i.e. consumers, producers, market makers, investors and governments. All agents require an environment that is relatively stable. Uncertainty, volatility is discouraging the average decision maker. One of the elements of this uncertainty is the evolution of the prices. Price fluctuations do impact on the decision making process.
Economic theory underlines that in a free market economy the market price reflects interaction between supply and demand: the price is set to equate the quantity being supplied and that being demanded. In reality the price may be distorted by other factors, such as tax and other government or central bank intervention through monetary policy.
Inflation is a situation whereby prices increase or to put it differently the purchasing power of money decreases. More precisely, Inflation refers to a general increase in consumer prices and is measured by an index which has been harmonized across all EU Member States: Harmonized Index of Consumer Prices (HICP). The HICP is the measure of inflation which the Governing Council of the ECB uses to define and assess price stability in the euro area as a whole in quantitative terms. The main headings of the Index are: food, alcohol and tobacco, clothing, housing, household equipment, health, transport, communications, recreation and culture, education, hotels and restaurants and miscellaneous (see Eurostat).
Deflation is the opposite. Extremes in both situations are pervasive. As shown above price levels fluctuate. The target (the red line) is to have an inflation of two (2) percent. The discussion in the Eurozone, today is rather avoiding deflation. See article at the end of this paper. A low inflation encourages the economic agents to act, consume or invest. A deflation does the opposite and may encourage major actors to postpone decisions, purchase later or invest later. It is a state of mind.
Inflation is slowing in the Eurozone, raising the risk of a slide into deflation and stagnation with the incapacity to generate jobs to bring down unemployment. Inflation is now less than half the central bank’s target level. Recently, the IMF (the International Monetary Fund) has expressed concern that weak prices mean there is little room for improvement of the economic situation. Besides, quite a few European banks are still very cautious about lending to households and businesses, or to each other, putting a downwards pressure on the economic recovery.
Quantitative definition of price stability (Source ECB)
The ideal situation would be “price stability” with an inflation rate of two percent. The definition of price stability according to the ECB is as follows:
While the Treaty clearly establishes the primary objective of the ECB, it does not give a precise definition of what is meant by price stability. The ECB’s Governing Council has announced a quantitative definition of price stability as “Price stability is defined as a year-on-year increase in the Harmonized Index of Consumer Prices (HICP) for the euro area of below 2%.” The Governing Council has also clarified that, in the pursuit of price stability, it aims to maintain inflation rates below, but close to, 2% over the medium term.
Benefits of the announcement by the ECB on price stability
The announcement makes the monetary policy more transparent, provides a clear and measurable yardstick against which the European citizens can hold the ECB accountable and provides guidance to the public for forming expectations of future price developments.
Focus on the euro area
The ECB’s definition of price stability makes clear that the focus of its monetary policy is on the euro area as a whole. This reflects its euro area-wide mandate. Therefore, price stability is assessed on the basis of price developments in the euro area economy.
Reasons for aiming at below, but close to, 2%
Inflation rates of below, but close to, 2% are low enough for the economy to fully reap the benefits of price stability.
It also underlines the ECB’s commitment to
- Provide an adequate margin to avoid the risks of deflation. Having such a safety margin against deflation is important because nominal interest rates cannot fall below zero. In a deflationary environment monetary policy may thus not be able to sufficiently stimulate aggregate demand by using its interest rate instrument. This
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makes it more difficult for monetary policy to fight deflation than to fight inflation.
- Take into account the possibility of HICP inflation slightly overstating true inflation as a result of a small but positive bias in the measurement of price level changes using the HICP.
- Provide a sufficient margin to address the implications of inflation differentials in the euro area. It avoids that individual countries in the euro area have to structurally live with too low inflation rates or even deflation.
Key interest rates (Source ECB)
The Governing Council of the ECB sets the key interest rates. The key interest rates for the euro area set by the Governing Council are:
- The interest rate on
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the main refinancing operations (MROs), which normally provide the bulk of liquidity to the banking system. The Euro system may execute its tenders in the form of fixed rate or variable rate tenders.
- The rate on the deposit facility, which banks may use to take overnight deposits with the Euro system.
- The rate on the marginal lending facility, which offers overnight credit to banks from the Euro system
Unconventional monetary policy or pragmatic monetary policy (source ECB)
Since the intensification of the financial crisis in September 2008, the ECB has introduced a number of non-standard monetary policy measures that are unprecedented in nature, scope and magnitude with the aim to safeguard the primary objective of price stability and ensure an appropriate monetary policy transmission mechanism. They consist of:
- Enhanced Credit Support
- The Euros
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system purchase of euro denominated covered bonds issued in the euro area.
- The EIB to become an eligible counterparty in the Euro system’s monetary policy operations
- Securities Markets Programme
- A fixed rate tender procedure
- The reactivation in coordination with other central banks, of the temporary liquidity swap lines
Comments by the ECB related to above measures (2010)
The Governing Council considers the above measures essential in order to ensure the effectiveness of the monetary policy transmission mechanism. In particular, above measures should help to mitigate the spillover of increased financial market volatility, liquidity risks and market dislocations in the access to finance in the economy. The sterilization of the interventions in the euro area public and private debt securities markets will ensure that the Securities Markets Program does not affect prevailing levels of liquidity and money market rates.
For further information do not hesitate to consult the source of this document www.cbe.org.