The normalisation phase: sequencing Let me now return to our ongoing monetary policy normalisation process. Our normalisation process entails a sequence whereby interest rate increases precede the reduction in our balance sheet, the so-called quantitative tightening (QT). There are at least two reasons for this. First, we have greater certainty about how changes in the policy rate pass through to financial conditions and to the economy than in the case of QT. Central banks have decades of experience in calibrating a rate hiking cycle to actual and prospective economic conditions, but we have far less experience in reducing the size of our balance sheet from such high levels. Second, monetary policy transmission in the euro area is highly dependent on bank credit. Loan pricing is typically benchmarked to short and medium-term rates. Policy rates are thus a more effective instrument to tighten monetary policy. Let me flag an additional consideration regarding the interaction between QT and interest rate policy. Both QT and interest rate policy affect the overall monetary policy stance. Therefore, the path of policy rates that is necessary to return inflation to its medium-term target also depends on how the central bank is implementing its QT. Going forward, how should our balance sheet normalisation proceed? First, a balance sheet reduction has already started with the automatic phasing-out of TLTRO III operations.
And we will work hard, as we have in the past, to try to find the right balance between the broad objectives of stability and security and the efficiency of the system. BIS Review 59/2004  5