HIGHLIGHTS

• The shift from deflation to inflation concerns in the aftermath of the pandemic and the war in Ukraine triggered a sharp turnaround in the ECB’s monetary policy stance. It hiked key rates by a cumulative 450 bps and started to reduce its balance sheet. 
• We think that the move to a floor system in reserve operations and green TLTROs are key factors that will keep the balance sheet some € 2 to 2.5tr higher than before QE. 
• Still, the balance sheet will need to be reduced significantly. We see passive quantitative tightening (QT), i.e., the non-reinvestment of maturing bonds, as the preferred and most likely way to reduce the € 5tr of policy-related assets. 
• Under these assumptions, passive QT must last until around the end of 2028. However, in the risk case of active QT starting in early 2024, the target balance sheet would already be reached by late 2026 if we assume that outright selling doubles the QT pace. 
• The reduction of the still ample excess liquidity (EL of currently € 3.5tr) to the upper target range of € 1.4tr needed if the ECB were to formally adopt the floor system will also be slow in our baseline scenario. An increase in the Reserve Requirement Ratio (RRR) from 1% back to 2% or even higher would help and mop up liquidity.
• The ECB has started to reinvest maturing bonds in a carbon-neutral manner rather than in a market-neutral way to promote the green transition and to internalise the negative externalities of emissions. While the ECB is likely to continue on this path, there are unwelcome side-effects and the overall contribution to achieving the climate targets is not very sizeable.
• The impact of QT on government bond markets is difficult to disentangle from other factors. It increases the term premium via the so-called portfolio rebalancing channel. However, given the ECB’s cautious approach, the impact on euro area government bond yields will remain moderate.
• QT also has an impact on the swap market. The downward trend in swap spreads is seen to continue as the volume of collateral available to the market rises.

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