This is one of the goals of fiscal and monetary policy. Its aim is to support sustainable rates of economic activity. This sets a low target for either inflation or deflation.
The ECB operates under the guidance of below 2% on the Harmonised Index of Consumer Prices (HICP).
On the other side of the Atlantic, the Federal Reserve has a different set of targets. The Federal Reserve Act was amended in 1977 to give the following mandates:
- maximum employment
- stable prices
- moderate long-term interest rates
Over the years, the Fed has concluded that a 2% annual increase in the personal consumption expenditures price index (PCE). This is the metric it adopted in 2011.
Benefits
According to the ECB the benefits of price stability are as follows:
- It allows us to avoid the inefficiency costs arising from the presence of nominal rigidities.
- It reduces the inefficiency costs created by inflation being a tax on money balances.
- It avoids adverse redistributive effects of inflation. The adverse effect of inflation on income and wealth differs across different cohorts of society, with higher inflation especially detrimental for low-income households with limited investment options.
- It avoids adverse interactions of inflation with taxation. The presence of inflation creates distortions because taxes are levied in nominal terms and there is no full indexation. For instance, if your nominal income grows in line with inflation but the tax brackets are not updated in line with inflation, you end up paying more taxes even if your inflation-adjusted income has not changed. By keeping inflation low and stable this effect is reduced.
- It reduces unexpected changes in inflation, which create distortions. For example, if there is an unanticipated increase in inflation, the value of savings goes down and the value of debt goes down, which transfers wealth from savers to borrowers.
- It decreases the volatility of inflation, which in turn lowers uncertainty and market interest rates and this motivates people to invest.
- It contributes to a more stable financial system.
- It helps to maintain social cohesion and stability. History has shown that episodes of high inflation as well as episodes of deflation, or persistently falling prices, tend to be associated with social unrest. Unstable inflation particularly affects low-income households because they have fewer resources to protect themselves. When prices are stable, everyone is better off: price stability supports economic growth and employment, and allows people to make more reliable plans when taking decisions about borrowing, saving, and expanding businesses.
Much of what the central banks do is to attempt to manage expectations. This is especially true with prices. People have a tendency to act upon what they believe the future will hold. If they are pessimistic, a cash position is far more likely than massive spending of investing. Credit card balances are reduced in preparation of job loss or some other setback.