Back to Normal? Balance Sheet Size and Interest Rate Control

The European Central Bank (ECB) has recently started quantitative tightening (QT), marking the end of eight years of balance sheet expansion. The peak of the ECB’s balance sheet expansion saw monetary policy assets accounting for around 56% of Eurozone GDP, a substantial amount historically and in international comparison. The ECB is now attempting to return its balance sheet to pre-quantitative easing (QE) levels, but will this be possible given the autonomous factors that are beyond their control?

The Unconventional Monetary Policy Tools

The first wave of balance sheet expansion responded to the low-inflation environment that followed the Eurozone sovereign debt crisis. As a result, the ECB employed unconventional monetary policy tools, which included targeted longer-term refinancing operations (TLTROs), and conducted asset purchases to raise inflation and stimulate economic activity. These measures led to a significant increase in monetary policy assets and central bank liabilities in the form of excess reserves.

The Pandemic’s Impact

The second wave of balance sheet expansion came with the ECB’s response to the pandemic. Launching the pandemic emergency purchase program (PEPP) and adjusting the third series of TLTROs led to a significant increase in monetary policy assets. These measures were vital in protecting the Eurozone economy from falling into a full-blown financial crisis and economic depression.

The Fall in Balance Sheet Growth

Since last July, the growth of the ECB’s balance sheet has halted, and it has reduced in size since the beginning of March. In addition, banks began repaying their outstanding TLTRO loans, and the ECB has ceased reinvesting maturing securities bought under the asset purchase program (APP). As a result, the ECB expects a meaningful decline in the size of the balance sheet over the coming years, which will reduce excess liquidity. However, the size of the balance sheet will not return to pre-QE levels.

Autonomous Factors

The size of the ECB’s balance sheet is primarily driven by growth in reserve requirements and what is known as autonomous factors, which are beyond the Eurosystem’s control. Independent factors include official sector deposits and, most importantly, banknotes in circulation, which have increased since 2007. As a result, excess liquidity will continue if autonomous factors increase in line with historical patterns.

Related Facts

• The ECB’s balance sheet size is vital for interest rate control.
• The ECB’s key policy rate had already been lowered into negative territory in 2014 and was approaching the effective lower bound, leading to unconventional monetary policy tools.
• The size of the ECB’s balance sheet is expected to decline meaningfully over the coming years, thereby reducing excess liquidity.

Key takeaway

The ECB’s balance sheet has expanded substantially over the last eight years in response to the low inflation and pandemic. While the ECB plans to return its balance sheet to pre-QE levels, the rise in autonomous factors makes it unlikely that excess liquidity will significantly reduce, and the balance sheet will not shrink to pre-QE levels.

Conclusion

The ECB’s balance sheet expansion was necessary to prevent another financial crisis and economic depression, but it has led to significant concerns, such as excess liquidity. While admirable, the ECB’s attempts to return to pre-QE levels may be challenging, given the rise in autonomous factors. It remains to be seen whether the ECB can reduce excess liquidity. Rest assured; this topic will continue to be at the forefront of economic discussions for the foreseeable future.