Inflation explained: What lies behind and what is ahead?

Briefing 02-08-2022

Inflation explained

Understanding inflation dynamics requires an understanding of the underlying concept and how it is measured. Inflation is defined as a process of continuously rising prices and falling purchasing power. In other words, a general and broad-based increase in the price of goods and services over an extended period. The main objective of central banks is to keep prices stable, to preserve the integrity and purchasing power of people's money. The most common inflation indicator measures the average change in the price of a basket of consumer goods and services over time. The closest approximation of what people intuitively understand by the term inflation is the change in their cost of living. The Harmonised Indicator for Consumer Prices (HICP), against which the European Central Bank (ECB) assesses the achievement of its price stability objective, is based on this concept. Strong inflation momentum for a broad set of goods and services in the consumer basket led to a record high inflation rate in June 2022, standing at 9.6 % in the EU and 8.6 % in the euro area, driven mainly by energy and food prices, which rose by 42 % and 8.9 % respectively. Inflation is expected to remain significantly above the euro area inflation target of 2 % for some time, due to continued geopolitical uncertainty and persistent supply bottlenecks. In its monetary policy meeting on 21 July, the ECB raised interest rates for the first time in over a decade by 0.5 percentage points and unveiled a new Transmission Protection Instrument. The latter would help the ECB to counter unwarranted, disorderly market dynamics and to make secondary market purchases of securities under certain conditions, thus preventing financial fragmentation within the currency bloc. At its meeting, the ECB also suspended forward guidance on the size of future rate rises in the interest of more flexibility. In conclusion, the latest ECB decision reflects increased efforts to bring inflation back to the 2 % target through a front-loaded policy rate hike, while putting in place an additional tool to counter unwarranted fragmentation. This is an update of a Briefing published in April 2022.