Inflation in the Euro-Zone – understanding its impacts and the ECB policy

by Mathilde Lallemand, 5 minutes

The European Central Bank (ECB), located in Frankfurt, is the European institution responsible for our money, the Euro, and the 19 countries using it as a currency. The central bank is independent of the other bodies of the Union or governments. The ECB has two main objectives: keeping prices stable (which is done by controlling and maintaining a decent inflation rate) and safeguarding the currency.  

What is inflation?

Keeping prices stable or ensuring that the Euro does not fluctuate too much relates to the phenomenon of inflation. Inflation is the general increase in the overall price level of goods and services typically bought by us. The bank defines a basket of goods and services and measures its average price. The official measurement is called the Harmonised Index of Consumer Prices (HICP) and is based on annual changes.

The Harmonised Index of Consumer Prices is composed of the following elements:

• Food and non-alcoholic beverages

• Alcoholic beverages & tobacco

• Clothing and footwear

• Housing, water, electricity, gas, and other fuels

• Furnishings, household equipment, and routine household maintenance

• Health

• Transport

• Communication

• Recreation and culture

• Education

• Restaurants and hotels

Why does inflation matter?

Since the general prices increase, you now pay more than you used to for your purchases which negatively impacts your purchasing power.  

High inflation is harmful as it reduces economic activity, and people have fewer funds available to consume, slowing down the circle. On the societal aspect, inequalities are deepened, especially affecting the middle and low-income classes.

However, the ECB does want to achieve low inflation or “negative” inflation rates either. Deflation, contrary to inflation, is a sustained and general fall in prices. It creates a vicious circle because people postpone today’s purchases to take advantage of lower prices later on. The economy also slows down as businesses are not able to sell their goods and services, endangering growth. 

Current Inflation rates

The ECB controls prices by working with other national central banks (i.e. Dutch National Bank), and commercial banks (for private & business purposes). As a result, the ECB acts as a supervisor and lender of national banks which are in turn responsible for lending and overseeing commercial banks. The ECB’s target is to achieve 2% inflation in the medium term (approx. 10 years), which has been maintained since 2017.

Figure 1 – HICP inflation rates January 2015-January 2022

In March 2022, the flash estimate of inflation (or the early estimate based on the most recent data) has skyrocketed to 7.5% in the 19 countries of the Eurozone as a result of the last two years of the pandemic and the recent developments concerning the war in Ukraine. These two events are an example of externalities affecting the global economy.

Looking at the sub-inflation rates amongst the HICP categories, “housing, water, electricity, gas, and other fuel” (13.4%) & “transport” (10.3%) are encompassing a major part of high prices. Some countries are experiencing serious inflation rates, such as Lithuania, where inflation on food and non-alcoholic beverages has reached 15.4%. 

The central bank developed an online interactive index where you can check inflation per HCIP category and/or country. 

Controlling inflation 

The ECB aims to achieve its goal by controlling the financial system with a few financial instruments. The main ones are the key interest rate, asset purchase programs, or printing cash.

• The key interest rate is the interest rate at which the ECB lends money to national central banks.  The higher the interest rate, the higher the cost for citizens, businesses, and governments to borrow. As a result, the ECB expects the different parties to save by reducing the amount of money spent on goods and services or investments. In general, policymakers try to not have this rate fluctuate too much due to its direct and indirect effects on the global financial market.

• Asset Purchase Programs help to control the amount of money or “money supply” available in the global economy. The ECB can decide to issue securities to add more money to the system and reduce the value of the euro (decreasing inflation) or repurchase these assets to reduce the money supply and increase the value of the currency.

• Printing cash is also a financial instrument and is similar to Asset Purchases Programs. The money supply is increased when put into circulation. 

Policy brief – 10th of March 2022

Typically, the ECB reviews its monetary policy every quarter. Nevertheless, this trend has been adapted due to COVID-19 with more recurrent reviews to best sustain an uncertain global economy.

The central bank issued its most recent statement on March 10th describing the actions taken:  as a result of the war in Ukraine, the experts announced that they expect a general increase in prices, leading to inflation, especially in commodities and energy. Western sanctions also affect and are prone to further inflation. Moreover, it is not yet known how long this increase will be sustained in the future.

Thus, the ECB decided to conduct an Asset Repurchase Program (APP), where €40 billion in April, €30 billion in May, and €20 billion in June of securities will be bought back, depending on the aftermath of the current events impacting the global economy (i.e global supply chains tensions, pandemic, war).

While keeping a close eye on the APP, the policymakers will also alter the key interest rate, already agreed upon to 0.00% in April, 0.25% in May, and -0.50% in June respectively if all goes as planned.

To conclude, higher prices and high inflation shall remain high due to the general uncertainty in the economy, as mentioned before. The effect of the financial instruments cannot yet be observed due to their medium-term effects.

If you are interested in learning more about the ECB’s role or understanding how inflation impacts you more specifically (by calculating your inflation budget), check out the statistics insights on inflation.