What is inflation, and why does 2% matter?

Inflation is the speed at which prices rise. Statisticians track the price of a fixed basket of what households buy, from bread and rent to haircuts and train tickets, and compare it with the same basket a year earlier. In the euro area that measure is called the HICP (Harmonised Index of Consumer Prices), and it is calculated the same way in every EU country so they can be compared.

What 3% inflation does to your money

If inflation is 3%, €100 buys roughly what €97 bought a year ago. Two things follow:

• Your salary only buys more if it rises faster than prices. A 2% pay rise in a year of 3% inflation is a small pay cut in real terms.
• Your savings lose buying power if they earn less than inflation. Cash in an account paying 1% while prices rise 3% buys about 2% less each year.

Economists call this the difference between nominal (the number on the payslip or the account) and real (what it actually buys).

Why 2%?

The European Central Bank and the US Federal Reserve both aim for inflation of about 2% a year over time. Not zero, for two reasons:

1. When prices fall across the board (deflation), people and companies delay spending because things will be cheaper later, which can drag the whole economy down.
2. Interest rates can’t easily go far below zero. A little inflation leaves central banks room to cut rates when the economy needs support.

What pushes inflation up or down?

• Energy and food, which can jump quickly with harvests, wars or supply problems.
• Wages: when workers are scarce, pay rises, and companies pass some of that on.
• Demand: when everyone wants to spend at once, prices follow.
• The exchange rate: a weaker euro makes imported goods dearer.
• Interest rates: higher rates cool borrowing and spending, but with a delay of a year or more.

See the latest figures on the inflation chart, next to the central bank interest rates that respond to it.