The term inflation is used to refer to a persistent rise in the general price level over several periods of time. Prices for goods and services constantly change – some prices increase while others fall. We refer to inflation when there is an increase in not only prices of individual products but prices in general. The increase in prices is measured using the inflation rate – also called the rate of price increase. It indicates the percentage by which the price level has risen within a given period of time, e.g. a month or a year. Therefore, an annual inflation rate of 4 % means that goods and services cost on average 4 % more today than a year ago. Inflation causes the value of money to fall, as more money has to be spent to buy the same products. This implies that purchasing power of money decreases. Over a longer period, the loss in purchasing power can be considerable, even if the inflation rate may seem rather low at first glance.
As illustrated by the chart, at an annual inflation rate of 4 %, in ten years €100 only have the purchasing power of just under €68 today. After 50 years, one would only receive goods worth the equivalent of €14 today.
Deflation is the opposite of inflation. Deflation refers to a general, sustained decline in the price level.
The inflation rate provides information on the changes of the price level – i.e. the average of all prices in the economy. However, it is impossible to record the millions of individual prices for all goods and services in a timely manner. For that reason, a representative basket of goods is used to calculate the inflation rate. Such a basket of goods contains an appropriate selection of around 650 types of goods, each belonging to one of 12 categories, that are supposed to represent the typical consumer behaviour of a household. It therefore includes various dimensions such as food and clothing, housing rents and insurance premiums, as well as services such as hairdressing; but also infrequently purchased goods such as cars and washing machines. From each of the types of goods (e.g. canned soup, women’s sportswear and hearing aids), specific individual products are selected as part of the monthly data collection exercise and their prices are measured.
The basket of goods forms the basis for calculating the consumer price index (CPI) for Germany. It measures the average change in the prices of all goods and services purchased by households for consumption purposes. The percentage changes of this index represent the inflation rate. The inflation rate is suited to understand how consumer prices change on average over time.
The price of the basket of goods is calculated by multiplying the corresponding amount by the respective price for all of the goods included and adding the results together (total expenditure).
The changes in total expenditure are provided using the price index. To do this, the total expenditure of the first year (base year) is normalised to 100 (€300 equates to 100). This value serves as a reference variable for the following years.
On that basis, the price index for the subsequent years is calculated. More specifically, the value of the basket of goods in each subsequent year is divided by the value of the basket of goods in the base year. The result is multiplied by 100 to get the price index. For year 3: €450.00 ÷ €300.00 × 100 = 150
The inflation rate represents the relative price change based on the previous year. It is calculated as follows: The price index of the relevant year minus the price index of the previous year (for year 3: 150 - 120) divided by the price index of the previous year (120), multiplied by 100: (150-120)÷120 × 100 = 25%
In case of the consumer price index, the prices of the individual types of goods are included in the calculation with different weights. The corresponding weight is based on the share of consumer spending attributable to the relevant category of goods. To this end, various types of goods are grouped into categories of goods. There are 12 categories of goods that are grouped together with the corresponding expenditure shares in the weighting scheme.
The basket of goods is constantly updated at the individual product level. By contrast, the Federal Statistics Office deliberately keeps the weighting scheme of a base year constant for five years when calculating the consumer price index since the price index should only reflect the price changes and not changes in spending habits.
A distinction needs to be made between the consumer price index (CPI), which is used in this form only in Germany for measuring inflation, and the Harmonised Index of Consumer Prices (HICP). The HICP is a price index calculated across the EU and it is used to measure the development of consumer prices in the euro area. For the HICP to be calculated, every euro area country calculates an additional special consumer price index, using a harmonised method, in addition to the respective national measure of inflation. They then report the results, which are collected on a monthly basis, to the Statistical Office of the European Union (Eurostat). Eurostat summarises the submitted national inflation data and forms the Harmonised Index of Consumer Prices (HICP). The individual country data are incorporated into the HICP with different weights. The weights depend on each country’s share of total consumer spending in the euro area.
The percentage changes in the HICP indicate the inflation rate in the euro area. The HICP is therefore the key measure for assessing price developments and, thus, developments regarding purchasing power in the euro area.
Economic agents act in a forward-looking manner. They make decisions not only based on current developments, but also based on expected future developments. Expectations about future inflation play a significant role in that regard. Indeed, inflation expectations are an important factor in households’ consumption and saving decisions and in firms’ investment decisions. In addition, inflation expectations also affect wage and price setting.
Yet, the expectations of households and firms influence not only their own decisions, but also macroeconomic developments. If all agents expect prices to increase strongly, many of them will prepone planned purchases as long as those prices have not yet risen too sharply. This increased demand usually leads to rising prices, meaning that inflation expectations ultimately also affect the actual inflation rate itself. Therefore, long-term price stability is possible only if inflation expectations are stable and low.
To avoid high inflation rates and the resulting loss of purchasing power, the Eurosystem, consisting of the European Central Bank (ECB) and the national central banks participating in the euro, such as the Deutsche Bundesbank, pursues the objective of maintaining price stability. The Governing Council of the ECB, as the decision-making body of the Eurosystem, considers prices to be stable if the annual rise in the Harmonised Index of Consumer Prices (HICP) is less than 2 % over the medium term. In the pursuit of price stability, the Governing Council’s monetary policy measures are therefore geared towards keeping the inflation rate below, but close to, 2 % over the medium term. By communicating its notion of price stability openly and transparently, the ECB Governing Council also provides the public with a yardstick for assessing the success of its monetary policy.
Presenting the inflation target to the public in a transparent manner is also a means of influencing economic agents’ inflation expectations. These inflation expectations should be low and firmly anchored. Inflation expectations are considered to be firmly anchored if they do not deviate from a central bank’s price stability objective. If inflation expectations become “unanchored” – in the form of higher inflation expectations, for instance – this can jeopardise price stability (see the section “The role of inflation expectations”). The anchoring of inflation expectations is considered a key element of many monetary policy strategies.
In addition to anchoring inflation expectations, a central bank can use other instruments to maintain price stability. The most important of these monetary policy instruments is the policy rate. This is the rate of interest at which banks can borrow money from the central bank.
The policy rate influences the interest rates at which banks lend to each other (money market rates). Banks tend to pass on increases or decreases in money market rates directly to their customers, so changes in money market rates also affect bank lending rates.
Demand for such loans largely depends on the interest rate level on bank loans. To be more specific, when bank loans become more expensive for firms and households, demand for such loans generally declines. The opposite situation applies when loans become cheaper. In turn, the price and availability of loans ultimately influences how much money households and firms have available for consumption and investment. This influences the demand for goods and therefore ultimately price developments. Central banks thus have the option of raising or lowering the policy rate in order to ensure price stability.
At the same time, however, the policy rate can also be used to influence economic agents’ expectations. A policy rate hike can be interpreted as a signal for lower inflation rates in the future, whilst a cut to policy rates can be viewed as a signal for higher inflation rates in the future. This way, changes in policy rates can influence inflation expectations, which, in turn, affect wages, demand in the goods markets, prices and therefore the inflation rate.
Inflation uncertainty represents uncertainty about the future development of inflation. It therefore describes uncertainty about the level of expected inflation. Inflation uncertainty exists when economic agents are unsure what inflation rate to expect in the future. Based on this, individual inflation uncertainty and macroeconomic inflation uncertainty are distinguished from one another.
Individual uncertainty describes the personal uncertainty of individual economic agents considered in isolation. To gauge these agents’ uncertainty, the questionnaires for the Bundesbank’s study on expectations contain a question on the subjective probability distribution of the expected inflation rate. Specifically, participants are asked to assign a probability to different inflation scenarios or different inflation rates.
This involves distributing 100 points among the possible inflation scenarios. It is also possible to assign zero points to a scenario. The more points a participant assigns to the scenario, the more strongly they believe inflation/deflation to occur within this range.
Based on this question, individual uncertainty is determined by the number of intervals used. More precisely, the greater the number of inflation scenarios among which respondents distribute their 100 points, the greater their individual uncertainty about the future level of the inflation rate.
Macroeconomic inflation uncertainty goes beyond the level of individual economic agents and describes aggregate uncertainty about the future inflation rate. Put differently, macroeconomic uncertainty can be seen as disagreement among economic agents about the future level of inflation. It can be depicted as the standard deviation of the prevailing inflation expectations. It is calculated by deriving the standard deviation of the point estimates of respondents for the future inflation rate. The standard deviation describes the dispersion of the various estimated inflation rates around the mean of these point estimates. Simply put, it measures the average distance of all recorded point estimates for the future inflation rate from the mean value of the latter. Thus, it is a suitable yardstick for measuring uncertainty and disagreement surrounding inflation expectations.
The Deutsche Bundesbank can glean very valuable information from how uncertain an individual respondent is about inflation developments. As a respondent’s individual inflation uncertainty increases, so does the likelihood that their inflation expectations will change. Likewise, individual savings and spending decisions are influenced by this.
The degree of uncertainty about inflation expectations also provides indications of the credibility of monetary policy. Increased macroeconomic uncertainty can make it more difficult to implement monetary policy measures. In this context, it can also have a negative impact on macroeconomic developments.
As a result, it is vital for central banks to capture inflation uncertainty and understand how it develops. Monitoring inflation expectations and inflation uncertainty via surveys plays a key role in this.