The importance of price stability

Maintaining stable prices is the best way for central banks to contribute to increasing the well-being of individuals. Stable prices help ensure economic growth and stable employment and provide assurance that the money you have in your wallet today will be more or less the same as tomorrow. On the contrary, longer periods of excessive inflation or deflation have a negative impact on economic development.

The European Central Bank aims to keep the annual inflation rate (measured by the harmonized index of consumer prices, HICP) at a chosen low but positive value:

• Inflation at 2% over the medium term is considered high enough to protect the economy from the threat of a deflationary spiral (a spiral of falling prices). Although falling prices from the consumer’s point of view may appear to be favourable, a continuous and general fall in prices in the economy, which is not caused by more efficient production, is usually accompanied by economic decline. If consumers expect the price of the product to fall in the future, they will postpone its purchase. If everyone does this, businesses will have difficulty selling their products. As a result of declining demand, they may be forced to reduce or freeze wages, or even reduce staffing levels, leading to rising unemployment. Economic activity is beginning to slow or decline as consumers and businesses limit their spending and investments.
• Inflation at 2% over the medium term is also high enough for companies, sectors or national economies that run into minor difficulties to be able to deal with them without having to cut wages. Reducing nominal wages is problematic in practice. Moderate inflation is helping to cut back on rising real costs and improve competitiveness. The alternative is lower and less stable employment.
• At the same time, inflation at 2% over the medium term is considered low enough to protect the economy from very high inflation. High inflation can result in a spiral of rising prices, a loss of confidence in the currency, and its devaluation. This reduces purchasing power, which means that you will no longer be able to buy as much with your money as before. Follow-up measures to reduce inflation require major restrictions, which is very painful for citizens and businesses.

More at: https://www.ecb.europa.eu/ecb/educational/explainers/tell-me-more/html/stableprices.en.html