Reinterpreting price stability in a changing world: what works and what doesn’t

Every year, the European Parliament (EP) adopts a resolution on the European Central Bank’s (ECB) Annual Report. While this resolution is not legally binding, it is a crucial instrument for elected representatives to hold the ECB, an independent institution, accountable. 

This year’s draft resolution, authored by Belgian MEP Johan Van Overtveldt, raises several concerns. In two previous blogs, we have shown how it misunderstands central bank independence and fails to understand the impact of the climate crisis on the ECB’s mandate. A third issue, more technical but no less important, concerns the interpretation of price stability itself. This matters because when the ECB decides to change interest rates, raising or lowering the cost of borrowing money across the economy, it is in fulfilment of its primary mandate: maintaining price stability. 

The recent inflation surge has revived fundamental questions about how price stability should be understood and pursued. In Europe, inflation was largely driven by external supply shocks highlighting the limits of a narrow, short-term focus on inflation outcomes. 

In this blog, we take a step back to revisit the basics: what price stability actually means and why it matters. And, most importantly, how it should (not) be interpreted.

What is price stability, and why does it matter?

Price stability means keeping the purchasing power of money stable, by avoiding both rapid price increases (high inflation) and persistently weak or falling prices (deflation). Keeping prices stable matters because it underpins the smooth functioning of a market economy. When prices are broadly stable, households and businesses can better read economic signals and make sensible decisions about spending, saving and investing. Predictable inflation also reduces uncertainty for investors, supporting productive investment and long-term growth. 

Keeping prices stable is a constant challenge, influenced by multiple and often overlapping economic and structural forces. On the demand side, overheating economies, strong credit growth or large fiscal expansions can push prices up, while weak demand during recessions can lead to very low inflation or deflation. On the supply side, shocks such as energy price spikes, disruptions to global supply chains, geopolitical conflicts or extreme weather events can raise production costs and drive prices higher, in tandem with structural factors like climate change and demographic trends. In the EU, continued dependence on imported fossil fuels has been a particularly important source of price instability: swings in global oil and gas prices are quickly transmitted to consumer prices, as the inflation surge following Russia’s invasion of Ukraine made clear. 

In the Eurozone, keeping prices stable is the job of the ECB. For the ECB, this is not just one goal among many: under Article 127 of the Treaty on the Functioning of the European Union, maintaining price stability is its primary mandate. To deliver on it, the ECB operates an inflation-targeting framework, meaning that it aims to influence how fast consumer prices rise over time. 

To do so, the ECB adjusts interest rates and other monetary policy tools to influence borrowing, spending and investment across the economy. Importantly, its policy instruments are largely designed to manage the economic effects of price instability, rather than to directly address its underlying structural drivers. 

How the ECB has defined and delivered price stability

Although the EU Treaties establish price stability as the ECB’s primary objective, they do not define it. In 1998, the ECB’s Governing Council therefore adopted a quantitative definition: price stability meant keeping euro area consumer price inflation below 2% over the medium term. Although this time horizon was left intentionally vague to give the ECB flexibility, it is generally understood to mean around 1.5 - 3 years. In practice, this meant that prices did not need to stay below 2% every single year, as long as inflation remained low and stable over time.

In 2003, this definition was clarified as “below, but close to, 2%”.Importantly, the ECB emphasised that price stability applies to the euro area as a whole, not to individual countries. This framework shaped euro area monetary policy for nearly two decades, during which the dominant challenge shifted from inflation control to persistently low inflation following the Covid-19 pandemics.

In 2021, the ECB concluded a major strategy review. A key outcome was the adoption of a symmetric 2% inflation target. This change reflected a new economic reality: inflation had undershot the target for most of the previous decade, while interest rates had fallen close to their lowest possible level.

The ECB recognised that inflation that is too low for too long is not benign. Persistently weak price growth depresses wages, discourages investment and risks entrenching deflationary expectations. Once households and firms come to expect very low inflation, it becomes harder for central banks to stimulate demand and steer inflation back on  target.

A symmetric target treats deviations above and below 2% as equally undesirable. This helps anchor expectations and provides flexibility to tolerate temporary overshoots after periods of undershooting: an important feature when monetary policy space is constrained.

Why the EP draft report falls short 

This year’s European Parliament’s draft report is problematic for two main reasons.

First, it calls into question the ECB’s symmetric inflation target and suggests replacing it with a more qualitative notion of price stability, defined as a situation in which expected price changes do not significantly affect household and business decisions. While this may sound appealing, abandoning a clear numerical target would make monetary policy harder to implement and communicate. A symmetric 2% inflation target provides a simple and transparent reference point that helps anchor expectations, even when inflation temporarily moves above or below its target. Replacing it with a vague qualitative benchmark would weaken this anchor and risk undermining the ECB’s credibility at a time when public trust in institutions is already under strain.

Secondly, the draft report hints that price stability could be interpreted as stability of the price level itself, rather than stability in the rate at which prices change. The price level simply refers to the average price of goods and services at a given moment. Targeting it would mean committing to a fixed price path over time and actively correcting past deviations, rather than focusing on keeping inflation stable going forward.

The difference matters. Under inflation targeting, if a shock causes prices to rise sharply, the central bank aims to bring inflation back to its target from the new level. Under price-level targeting, the central bank would instead try to undo the past increase or decrease by pushing prices back towards their earlier path. In other words, inflation targeting is forward-looking, while price-level targeting forces policymakers to “make up” for past misses.

This approach would be economically risky for at least two reasons. First, a stable overall price level can conceal large relative price shifts across sectors or countries. Yet these relative price changes are essential signals in a market economy, guiding production, consumption and investment decisions. Trying to neutralise their effects would interfere with economic adjustment rather than support it. Second, price-level targeting would increase volatility in response to unexpected shocks, as the ECB would be compelled to overcorrect for past deviations. In practice, this could require deliberately inducing deflation or inflation, with a burdensome impact on growth, employment and low-income households.

How price stability could be reinterpreted

Despite these flaws, the EP draft report is correct on one important point: the interpretation of price stability should not be frozen in time. Structural shifts such as climate change, digitalisation, demographic ageing and geopolitical fragmentation affect inflation dynamics in ways that traditional frameworks struggle to capture.

If the ECB regularly reviewed its interpretation of price stability, it could adopt a more forward-looking and flexible approach that truly supports sustainable growth and protects household welfare. This is particularly relevant in light of the recent inflation surge, which was driven largely by external supply shocks, most notably Europe’s continued dependence on imported fossil fuels following Russia’s invasion of Ukraine.

Reopening the debate on price stability therefore makes sense.

A more promising way to rethink price stability is to focus on the time horizon over which it is pursued. In practice, the ECB operates with a medium-term horizon of roughly 2-3 years. While this approach has served monetary policy well in the past, it may no longer be sufficient in the face of long-term structural risks,most notably climate change.

Climate-related disruptions to food production, energy systems and markets are already affecting prices and are expected to intensify over the coming decades. A narrow focus on short-term inflation control risks overlooking these longer-term threats to price stability and reacting too late or too aggressively when their effects materialise.

Adopting a longer-term perspective would allow the ECB to consider whether tolerating slightly higher inflation in the short run, for example due to price increases linked to the green transition, could help prevent much more severe price instability in the future. It would also require the ECB to pay closer attention to the underlying drivers of inflation and to tailor its policy response accordingly.

Not all inflation shocks are alike. An increase in prices driven by external supply factors, such as higher energy costs, has very different economic implications from demand-driven inflation. In such cases, aggressively raising interest rates may do little to address the root cause and can even worsen the economic impact by slowing growth and investment without easing price pressures. Finally, a broader interpretation of price stability must take distributional effects seriously. The ECB’s recent emphasis on responding “forcefully” to inflation has paid limited attention to how interest rate hikes affect different groups, including low-income households, women and young people.

Reinterpreting price stability does not mean abandoning quantitative targets or embracing price-level control. It means embedding inflation targeting in a longer-term, structurally informed framework, one that recognises the sources of inflation, avoids overreaction to supply shocks, and accounts for the social consequences of monetary policy decisions.