Higher interest rates, excess liquidity and the ECB’s balance sheet

Higher interest rates, excess liquidity and the ECB's balance sheet

Fecha: septiembre 2023

Ignacio Ezquiaga and José Manuel Amor

Policy normalisation

SEFO, Spanish and International Economic & Financial Outlook, V. 12 N.º 5 (September 2023)

Eurozone monetary policy has become far more sophisticated since the onset of the Global Financial Crisis in 2007-2008. Although the ultimate price stability target has not changed and overnight rates remain the channel for policy transmission to the economy, the ECB’s balance sheet has taken on greater purpose relative to its traditional role as a support instrument for monetary policy, entering the field of financial stability and influencing not only overnight rates but also the entire rate curve via new and less orthodox instruments. This situation has led the ECB, along with most of the central banks, to build up a balance sheet of an unprecedented size. Indeed, excess liquidity currently stands at 3.6 trillion euros, compared to 4.8 trillion in September 2022. The situation has sparked controversy, such as that surrounding its remuneration structure; misunderstandings with respect to the importance of quantities in monetary decisions; and unknowns, including questions about the exit strategy and impacts on bond market premiums. Against that backdrop, with the ECB since 2022 on a policy path of “normalisation”, it is timely to ask what that implies and whether it is possible to return to the way things were prior to 2007. Given that excess liquidity is determined by factors exogenous to monetary policy and can coexist with it indefinitely, even if the policy stance is restrictive, as it is now.

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