For the central bank to maintain price stability over the medium term, we know that monetary policy must not be overburdened with other objectives: it needs to be conducted within an institutional framework which rules out any type of fiscal dominance. I do not need to elaborate further on how profligate fiscal policy can eventually produce inflationary pressures. A ‘lax’ fiscal authority which seeks to avoid the short-term political costs associated with enforcing fiscal discipline could be tempted to finance its budget through money creation. Indeed, inflation erodes the real value of public debt. However, such an outcome can be ruled out in the euro area because of the existing institutional arrangements. The Treaty establishing the European Community assigns responsibility for monetary policy to the ECB and unambiguously entrusts it with the primary objective of maintaining price stability. To fulfil this responsibility effectively, the ECB and the national central banks have been granted a high degree of independence. Under Article 101(1) of the Treaty, central banks are also prohibited from extending credit to, or purchasing public debt instruments directly from, the primary market. By preserving the financial independence of the ECB and the Eurosystem and the integrity of their balance sheet, this prohibition makes monetary policy more credible. In the same vein, the prohibition also helps to strengthen fiscal discipline and thereby to promote the smooth functioning of Monetary Union. The Stability and Growth Pact (SGP) is an additional measure to ensure fiscal discipline and the long-term sustainability of public finances.

Inflation expectations  Inflation expectations cannot be observed directly, but approximate measures can be derived indirectly in three different ways: asking a sample of consumers, surveying professional forecasters and extracting information from financial markets. Let me elaborate. The European Commission conducts a poll every month in which it seeks consumers’ opinions on inflation developments in the euro area, in particular their perceptions of current inflation developments and their expectations for the next 12 months. These two measures are plotted in Chart 10, together with actual inflation. Consumers’ expectations have declined strongly in recent months, reaching a record low in May (the survey started in 1985). Most respondents thought that prices would either remain unchanged or fall in the next 12 months. But this is not really the same as expecting deflation. The second way of measuring inflation expectations is via the ECB’s Survey of Professional Forecasters. It suggests that most respondents regard deflation as unlikely. In the second quarter of 2009, none of the 50 participants reported a negative point estimate for 2009, and two participants reported a point estimate below zero for 2010. Together with point estimates, participants are also asked to assess the likelihood of future inflation falling within given ranges. Averaging the individual responses provides a summary of their assessment. As Chart 11 shows, in the most recent survey, respondents assigned an overall 18% probability that annual inflation will be negative in 2009 (left side of the chart), which is significantly higher than in previous rounds.