To avoid high inflation rates and the resulting loss of purchasing power, the Eurosystem, consisting of the European Central Bank (ECB) and the national central banks participating in the euro, such as the Deutsche Bundesbank, pursues the objective of maintaining price stability. The Governing Council of the ECB, as the decision-making body of the Eurosystem, considers prices to be stable if the annual rise in the Harmonised Index of Consumer Prices (HICP) is less than 2 % over the medium term. In the pursuit of price stability, the Governing Council’s monetary policy measures are therefore geared towards keeping the inflation rate below, but close to, 2 % over the medium term. By communicating its notion of price stability openly and transparently, the ECB Governing Council also provides the public with a yardstick for assessing the success of its monetary policy.
Presenting the inflation target to the public in a transparent manner is also a means of influencing economic agents’ inflation expectations. These inflation expectations should be low and firmly anchored. Inflation expectations are considered to be firmly anchored if they do not deviate from a central bank’s price stability objective. If inflation expectations become “unanchored” – in the form of higher inflation expectations, for instance – this can jeopardise price stability (see the section “The role of inflation expectations”). The anchoring of inflation expectations is considered a key element of many monetary policy strategies.
In addition to anchoring inflation expectations, a central bank can use other instruments to maintain price stability. The most important of these monetary policy instruments is the policy rate. This is the rate of interest at which banks can borrow money from the central bank.
The policy rate influences the interest rates at which banks lend to each other (money market rates). Banks tend to pass on increases or decreases in money market rates directly to their customers, so changes in money market rates also affect bank lending rates.
Demand for such loans largely depends on the interest rate level on bank loans. To be more specific, when bank loans become more expensive for firms and households, demand for such loans generally declines. The opposite situation applies when loans become cheaper. In turn, the price and availability of loans ultimately influences how much money households and firms have available for consumption and investment. This influences the demand for goods and therefore ultimately price developments. Central banks thus have the option of raising or lowering the policy rate in order to ensure price
stability.
At the same time, however, the policy rate can also be used to influence economic agents’ expectations. A policy rate hike can be interpreted as a signal for lower inflation rates in the future, whilst a cut to policy rates can be viewed as a signal for higher inflation rates in the future. This way, changes in policy rates can influence inflation expectations, which, in turn, affect wages, demand in the goods markets, prices and therefore the inflation rate.
