Analysing and measuring inflation in EU & US?

A consumer price index is an economic indicator designed to measure changes in the prices that households pay for goods and services. There is a Harmonised Index of Consumer Prices (HICP) for the EU. Every month, the national statistical offices use 'harmonised' methods to record consumer prices for a wide range of goods and services which are representative of their national household final consumption expenditure. Eurostat uses the data from national statistics offices to compile the HICP for the euro area and the EU as a whole. The harmonised method allows for comparisons between Member States' data.

The HICP plays an important role in guiding monetary policy, as it is the main measure used by the European Central Bank (ECB) to assess price stability in the euro area.

As high inflation has significant consequences for a society, it is important that inflation is controlled and managed effectively. It is therefore essential to have a harmonised measurement of inflation, using well agreed definitions and common methods to produce comparable results. The inflation measure must be relevant to economic policy-making and the chosen index must be of relevance for EU citizens by tracking over time the price changes that people observe in daily life.

In the EU, consumer price inflation is measured by the 'Harmonised Index of Consumer Prices' (HICP). 'Harmonised' signifies that all EU Member States follow the same methodology to compute the index. This EU-wide index guarantees comparability across countries.

While inflation is always present to some degree, this does not mean that EU citizens are less well-off because of it. Increasing wealth brought by economic growth generally balances the loss of purchasing power caused by inflation. Products may cost more, but people have more money to spend.

However, people can experience different real inflation rates in their daily lives. This is because of many, often complex factors, such as:

the type of household,differences in consumption patterns between countries and regions,

national taxation policies, etc.This section provides information on the diversity of real inflation rates among EU countries for a variety of individual products. It allows the user to compare these to the EU-wide inflation index, the Harmonised Index of Consumer Prices (HICP) (Measuring inflation in the EU).

In Germany in 1923, prices doubled every two days and workers were paid twice a day so they could buy food and goods before prices rose again. This is one of history's most spectacular examples of the negative consequences of inflation.

High and volatile inflation is harmful for the economy, consumers and businesses. Keeping inflation at a low level is a goal of economic policy-makers around the world.

But what exactly does inflation mean for a society?

Across the EU, in daily life, consumers encounter price changes – up and down – for the whole range of products and services they purchase. At any given time, these experiences contribute to individual perceptions about inflation, whether prices have risen, or are rising faster than before – or not.

Consumer opinion surveys show that EU citizens often ‘feel’ inflation to be higher than the actual price indices show. This difference leads people to ask themselves: “Why does the inflation rate seem not to apply to me?”

What forms perceptions of inflation?

Many factors can contribute to the perception of higher inflation than is actually measured by the Harmonised Index of Consumer Prices(HICP):

Focusing on frequently purchased items. A cup of coffee, a loaf of bread or bus tickets are frequent purchases that an individual might make every day, so these items weigh more in our judgement of general inflation. In recent years, the prices for such frequently bought products and services have increased significantly, especially in such categories as food (both at the supermarket and in restaurants), transport (for example bus tickets), fuel, tobacco, and entertainment (cinema tickets), personal care (hairdressers), and repair and cleaning services.

Thus, while prices for less-common purchases, such as new cars or insurance premiums, have hardly increased, or have even fallen in recent years – as is the case for IT equipment – there may still be an overall perception of higher inflation than is the case.

Remembering price rises more than price reductions. People tend to remember unpleasant experiences so that they can avoid them in the future. When the price of a product increases, this generally stays longer in the memory than a price decrease. This can lead to a bias in our perception of how prices are changing overall.

Inflation perceptions are persistent. Perceptions of higher inflation tend to persist in people’s minds. The changeover to the euro in 2002 is a good example to illustrate this: although the real HICP inflation rate for the EU showed no significant changes when euro cash was introduced, many citizens in the euro area believed that the euro brought relatively large prices rises with it. This belief still persists today and in some euro-area countries the divergence between measured inflation rates and perceived inflation has still not disappeared.

Ignoring changes in quality. A price may often increase because of an improvement in the quality of a product, such as better television screens or more convenient food packaging. In competitive markets, manufacturers seek to provide ever-more attractive features and advantages for customers. But these changes may come at a price. In such cases, the higher price is due to a quality increase and not inflation.

Influence of the media. Television and newspapers across the EU pay attention to inflation figures as they are of concern to their audiences. However, headlines reporting higher costs of living are sometimes based on limited data collected by the news organisations themselves. For this reason, while media reports may truthfully reflect individual price changes, they do not always reflect the overall inflation picture.

High and volatile inflation rates erode the value of people’s incomes and can harm sustainable economic growth and job creation (The consequences of inflation). Low and stable inflation rates are in everybody's interest. Therefore, inflation needs to be managed. How is this being done?

The two main ways to manage inflation are through monetary and fiscal policies.

Both policies work together by influencing the amount of money available in the economy. Making more money available in the economy means people will tend to spend more, driving up demand for goods and services. Higher demand tends to push the inflation rate up if it cannot be matched by supply (What is inflation?). Reducing the supply of money has the opposite effect.

Monetary policy – the role of central banks

Monetary policy consists of regulating the amount of money available in the economy. The amount of money needs to be proportional to the needs of the economy in order to ensure a sound level of employment and growth at low inflation rates.

Central banks – such as the European Central Bank (ECB) – run monetary policy. They do this, for instance, by raising or lowering their key interest rates.

Why are key interest rates so important?

Generally, key interest rates are the price at which central banks lend money to commercial banks. They determine the amount of money commercial banks borrow from central banks and in turn the rates they charge to individuals and businesses for loans. By this means, the central bank is managing the money supply or ‘liquidity’ in the economy.

If banks increase their interest rates:

Loans become more expensive;

People borrow less money to buy houses or new cars, for example;

People prefer to save rather than to spend;

There is less money in circulation and demand falls;

A fall in demand generally leads to a fall in prices, which means the inflation rate also falls.

Conversely, if banks reduce their interest rates, borrowing becomes less costly, more money is injected into the economy, demand grows and inflation rates go up.

When inflation is low and stable, interest rates can also be kept low.

Monetary policy in the EU

In the EU as a whole, monetary policy is the responsibility of the central banks of all 27 EU Member States and the European Central Bank (ECB). The central banks and the ECB form the European System of Central Banks (ESCB). Within this grouping, the national banks of theeuro-area Member States and the ECB form the Eurosystem.

The ECB and the central banks in the Eurosystem manage the monetary policy in the euro area. Their primary objective is to ‘maintain price stability', defined as an inflation rate below, but close to, 2%. Since the advent of the euro, the Eurosystem has mostly achieved this goal, particularly when compared to earlier decades.

Chart: Interest rates on money loaned by the European Central BankWhy price stability is important

With a predictable rate of inflation, people can make well-informed decisions about their future purchases and investments. Maintaining price stability also avoids prolonged periods of inflation or deflation, which is a persistent and self-reinforcing decline in a very broad set of prices. One example of harmful deflation is the Great Depression of the 1930s, when restrictive monetary policy contributed to a rapid and strong decline in spending which led to a fall in prices and a decline in economic activity.

Why is the target below, but close to, 2%?

Inflation rates of below, but close to, 2% are low enough for the economy to fully reap the benefits of price stability. This target provides an "adequate margin to avoid the risks of deflation".

Inflation and fiscal policy – the role of governments

Fiscal policy refers to how much and in which way governments decide to collect and spend money, i.e. the budget. A government usually collects revenues through levying taxes or fees on goods, services or incomes of businesses and individuals. On the other hand, it spends money on, for instance, social assistance or infrastructure projects.

Tax rates and government spending of the money it collects and borrows plays a significant role in most economies. The revenues of a government reduce the money available for people to spend. On the other hand, when a government spends by investing in infrastructure or services it puts money into the economy, which raises demand.

So fiscal policy can alter the drivers of inflation – supply and demand – and thus cause inflation to rise or fall.

Coordinating fiscal policy – the Stability and Growth Pact and the role of the European Commission

In the EU, fiscal policy is the responsibility of the Member States, including those in the euro area. However, the 27 Member States have agreed to coordinate their fiscal policies through the guidelines laid down by theStability and Growth Pact (SGP) and the Treaty. The Pact’s most important elements are the requirement to keepgovernment deficits below 3% of gross domestic product (GDP), and government debtbelow 60% of GDP.

The SGP is intended to ensure sound and sustainable public finances. Along with the single currency and the euro area’s single monetary policy, it is an integral part of theEconomic and Monetary Union (EMU). The European Commission is charged with monitoring compliance to the rules of the SGP which it does in co-operation with the Member States.