Price stability

Price stability is a goal of monetary and fiscal policy aiming to support sustainable rates of economic activity. Policy is set to maintain a very low rate of inflation or deflation. For example, the European Central Bank (ECB) describes price stability as a year-on-year increase in the Harmonised Index of Consumer Prices (HICP) for the Euro area of below 2%. However, by referring to "an increase in the HICP of below 2%" the ECB makes clear that not only persistent inflation above 2% but also deflation (i.e. a persistent decrease of the general price level) are inconsistent with the goal of price stability.^[1]

In the United States, the Federal Reserve Act (as amended in 1977) directs the Federal Reserve to pursue policies promoting "maximum employment, stable prices, and moderate long-term interest rates".^[2] The Fed long ago determined that the best way to meet those mandates is to target a rate of inflation of around 2%; in 2011 it officially adopted a 2% annual increase in the personal consumption expenditures price index (often called PCE inflation) as the target.^[3] Since the mid-trend 1990s, the Federal Reserve's measure of the inflation trend averaged 1.7%, a mere 0.3% shy of the Federal Open Market Committee’s 2% target for overall PCE inflation. Trend inflation as measured by the price index of core personal consumption expenditures (PCE) – that is, excluding food and energy – has fluctuated between 1.2% and 2.3% over the past 20 years.^[4]

In managing the rate of inflation or deflation, information and expectations play an important role, as explained by Jeffrey Lacker, President of the Federal Reserve Bank of Richmond: "If people expect inflation to erode the future value of money, they will rationally place a lower value on money today. This principle applies equally well to the price-setting behavior of firms. If a firm expects the general level of prices to rise by 3 percent over the coming year, it will take into account the expected increase in the costs of inputs and the prices of substitutes when setting its own prices today."^[5]

References

1. ""The definition of price stability", European Central Bank, on line (April 5 2017)". Retrieved 5 December 2017.
2. Public Law 95-188 (Nov. 16 1977).
3. "The Fed's plan to hike interest rates". The Economist. Retrieved 5 December 2017.
4. Cecchetti, Stephen; Schoenholtz, Kim (28 March 2017). "The Fed's price stability achievement: A case for Federal Reserve independence". Retrieved 5 December 2017.
5. "The Outlook for Inflation and Inflation Expectations - Speech, Jeffrey M. Lacker, March 21, 2016 - Federal Reserve Bank of Richmond". www.richmondfed.org. Retrieved 5 December 2017.