Our future actions will take into account these past decisions and their transmission lag to activity and inflation. And, of course, future decisions will be conditioned by the inflation outlook, including the economic prospects and, therefore, the higher probability of a recession that we are currently observing. Why did the ECB engage in asset purchases and TLTROs? To understand the next steps in our normalisation of monetary policy to combat inflation, it is helpful to step back for a moment and consider briefly how we arrived at the current monetary policy situation, characterised by a historically large Eurosystem balance sheet. Over the past 15 years, the euro area has been hit by a series of major recessionary shocks. First, in 2008-2009, we endured the great financial crisis. Second, as that crisis drove up public debt levels, several euro area countries were hit by a sovereign debt crisis. Recovery from those two major recessions was a slow process, and the euro area economy was only just beginning to return to normality in 2020 when the COVID-19 pandemic caused a worldwide economic shutdown. The main conventional tool in central banks’ policy toolkit are short-term policy interest rates. But following the sequence of huge negative shocks that have buffeted Europe and the rest of the world in recent years, interest rate cuts alone were insufficient for economic stabilisation, as the central bank cannot push its policy rates much below zero. 5 This was the conundrum facing the ECB around 2015.
Since the financial crisis, we have been de facto operating a “floor” system, characterised by ample excess reserves and interbank rates pegged to the DFR. This floor system, similar to that adopted by the Federal Reserve, is different from the “corridor” system that we operated before the crisis, which was characterised by a leaner balance sheet and scarcity of reserves. 10 The decision we take in this respect, as well as regarding the desired long-run composition of assets and liabilities, will anchor the desired size of our balance sheet. 10  Fo r an in-depth discussion see Chapter 3, Banco de España Annual R eport 2018, and Arce, Nuño , Thaler and Tho mas (2020), “A large central bank balance sheet? Flo o r vs co rrido r systems in a New Keynesian enviro nment”, Journal of Monetary Economics , Vo l. 114, pp. 350-367. 6  The potential impact of reducing the size of the balance sheet Once we reach the point of reducing asset holdings acquired through the APP, the crucial question is how strong an effect this form of quantitative tightening will have on long-term interest rates. It is tempting to see quantitative tightening as simply the opposite of quantitative easing. In this light, our experiences with QE over the past decade and more may give us some idea as to how large the effects of QT may be.