What is Inflation and How Does the EU Plan to Minimise It?

By Eleonora Pizzini and Petra Simpalean, 9 minutes

Copyright: Bruno Neurath Wilson - unsplash.com

Although not as central to the daily newspaper narrative as the European Commission or the Commission President, the role of the European Central Bank (ECB) is crucial and affects European citizens more directly than may be perceived. After the economic crisis arose from the Covid-19 emergency, and the negative economic impact of the war between Russia and Ukraine, EU Member States have been searching to adopt different monetary policies to stabilise the economy. To reach this goal, in late October 2022, the ECB board approved an interest rate hike to counter rising inflation. However, things might keep turning bad for a while before they eventually start to get better. Specialists believe that, in 2023, there will be significantly weaker growth and higher levels of inflation in comparison to what the European Central Bank forecasted. But the question is: what is the EU planning to do about it? And finally: how do those measures touch citizens?

Role of the European Central Bank

In order to better answer these questions, we first need to take a closer look at one of the institutions of the EU: the European Central Bank. The ECB’s main purpose, according to European Treaties, is to keep prices stable; this allows economic growth and employment to be generated. Other roles of the ECB include: keeping inflation under control; ensuring the safety of banking systems; developing and issuing euro banknotes; helping to preserve financial stability.

To achieve the goals of price stability and economic growth, the ECB sets a maximum inflation level of 2% in the medium term. The fact that an upper level is a negative sign for the economy is fairly obvious, but also low inflation is not a positive indicator for the economy, and the ECB tries to avoid too much negative inflation. But why is it so critically important to have a limit on inflation in economic terms? Placing a limit allows one to make accurate forecasts over the course of years and thus also to avoid massive currency crises in the event of other exogenous crises.

Understanding the policies implemented by the ECB and their purpose can prove to be complicated. It is essential to pay closer attention to these policies, as they have a substantial impact on the EU and its economy.

What is inflation?

Inflation occurs when the cost of goods and services within an economy rises exceptionally high, thereby reducing the purchasing power of citizens and with the risk that the value of money will decline over time. This is why the role of the ECB and other national central banks is of paramount importance. To better understand inflation and why it decreases or increases, it is necessary to comprehend the dynamics behind it. The economic interpretation of inflation defines it as a sustained universal and broad-based increase in the cost of goods and services. In other words, consumers, with €1, can buy fewer products or services today than they could yesterday.

The most popular inflation indicator involves calculating the average annual change in the cost of a specific basket of products and services. This can be done by comparing its price from year to year, or by comparing a specific year [nda so-called base] to the current year. Changes in one's cost of living are the closest way by which people intuitively understand the term inflation. This idea serves as the foundation for the Harmonized Indicator for Consumer Prices (HICP), which the European Central Bank uses to measure the success of its price stability objective. All EU countries are required to use this indicator because it enables comparisons between member states. This is a very efficient way in which the ECB keeps track of how prices change in the European economy. 

To date, with the start of the war in Ukraine in March 2022, there has been a constant increase in the cost of goods and services for European citizens. Many trades have been affected directly, such as energy agreements between Russia and the EU, and others more indirectly, such as trade in wheat, a less important commodity for the EU. The increase in energy prices is crucial because, in measuring the inflation index (HICP), the weight of this good has greater importance: in general, goods on which people spend more have greater weight in the calculation, compared to goods that cost less. 

Inflation within the Union and increase in Interest Rates

The European Central Bank's most important tool to indirectly influence inflation is the control of interest rates: they can either increase the rate at which the economy grows or decrease it. This is done by a rise or a decrease in these rates. More specifically, by lowering interest rates, the economy is stimulated, and inflation rises. To ensure that inflation is not too excessive, an increase in interest rates seeks to slow the economy somewhat down. Control over inflation levels makes it possible, as we have premised, to make economic projections and take measures to avoid drastic crises within the European economy.

The most recent data on European inflation show that October was over +10 per cent [nda +10.6%], up from +9.9% recorded in September. For a quick comparison of our economy, the U.S. recorded +8.2% inflation in September - still higher than the Federal Reserve's (FED) forecast -, while the U.K. recorded inflation at +9.9% - down from +10.1% in August. Clearly, the scenario presented leads to the assumption that an economic recession is imminent: high inflation rates tend to lead companies to reduce production and, at the same time, to increase their prices.

In order to reach back the +2% inflation level target set by the ECB, on October 27th, 2022, the bank’s Governing Council issued a press release to establish an increase in interest rate within the eurozone. This measure makes it possible to forecast a stagnant economy for the first quarter of 2023, but with inflation expected to go down to +5.5% - thus still high for next year - but then to reach +2.4 per cent in 2024. The levels still remain higher than the ECB's initial target, but they allow for the avoidance of an economic crisis. Moreover, this measure is not an isolated initiative of the ECB: the FED and the Bank of England have also taken similar actions to avoid falling into a recession.

What does an increase in interest rate mean for citizens?

Briefly: it discourages them from accessing credit (mortgages, loans, and so on) so that less currency is in circulation, which pushes inflation down. In this way, citizens are unconsciously forced to save, which culminates in a slowdown in spending. This mechanism of prioritising savings, from its side, acts on the aforementioned process of increased price by businesses: in an economy where consumers pay more attention to the purchases they do, prices are still raised, but at a slower pace, in order to encourage minimum spending.

More in detail, because interest payments are lower when interest rates are low, borrowing is considerably more affordable. Low-interest rates make it easier for people and businesses to borrow money and spend it, but they also make it less probable for them to save money because they get less interest. Additionally, demand rises if people and corporations can spend more money. And prices increase as demand increases. An increase in interest rates helps slow an economy down: with higher rates, borrowing money becomes more expensive, which reduces the aggregate supply in the market. As aggregate supply decreases, prices decrease. Resulting in people and businesses reducing their spending and lower inflation.

What other measures have been taken by the ECB?

Reaching the optimal inflation level of 2% is clearly not an easy task, but to counter the rise in price, the first possible action done by the ECB was of raising interest rates by 200 basis points over the course of their last three policy meetings. Basis points are a unit of measurement used to calculate financial instruments, especially interest rates. One basis point equals 1/100 of 1%. Thus, an increase of 200 basis points represents a 2% increase in interest rates, which is a relatively high number. 

Aside from this first manoeuvre, the ECB also unveiled plans to scale back bank subsidies, which are loans stipulated by the ECB with banks. This is done in order to force banks to repay trillions worth of euros. The subsidies were progressively hurting central bank profitability and, consequently, depriving the governments in the eurozone of much-needed money. 

In order to better match minimum reserves with money market conditions, the ECB will also lower the compensation of the reserves kept by credit institutions, and the minimum liquidity that banks are required to retain. In the future, it will treat those funds differently and apply the deposit rate instead of the refinancing rate. 

Lastly, the European Central Bank unveiled a new Transmission Protection Instrument (TPI). This Instrument effectively controls monetary policy and ensures that it is uniformly applied in the eurozone. The scope of this new tool is to ensure that the goal of price stability is reached. You can read more about the TPI here.

How are citizens affected by these measures?

In a more tangible and direct way, people who have mortgages or loans with banks or credit agencies are affected immediately, as there is a direct increase in the interest rates to be paid on stipulated agreements. However, citizens are also affected in a less influential way: in fact, the prices of basic goods also tend to increase, although proportionately less than the direct increases in interest rates. Still, when grocery shopping or buying other products, everyone can notice higher prices on usual goods.

On a good note, however, the ECB finds that it is common that consumers perceive inflation to be higher than it actually is. The reasons for this perception are numerous, including people’s increased focus on a price when it is rising, but lack of attention to the same toward a falling price; or the common association of price increase with inflation, while the difference could be due to other reasons, such as higher quality in a product. Therefore, even if we are currently experiencing high prices, our negative perception should not influence our long-term judgement and decisions.

It is clear that people are facing challenging times, as inflation has certainly been in the limelight of many citizens' concerns and governments' agendas this year. By increasing interest rates in a dramatic manner and adopting plans such as the TPI, the European Central Bank is devising a contractionary monetary policy. Learning what is being done to tackle inflation is mandatory for each citizen in order to stay informed and to ensure that we are capable of making smart decisions.

You can read more about the European Central Bank and its policies in our other article: Inflation in the eurozone: understanding its impacts and the ECB's policy