This range for the terminal rate has been obtained assuming that the Eurosystem maintains the size of its asset portfolio under the APP and PEPP constant over a horizon consistent with our communication on the PEPP (for which reinvestments are foreseen to extend until end 2024) and with survey-based expectations on APP (for which the reinvestment horizon is more open-ended). However, in the case of the APP the ECB could potentially decide to start reducing its asset stock earlier than markets currently anticipate. Given our understanding of the way asset purchase programmes work, such a course of action would have a downward effect on the terminal rate.17 This is because, if we announce our intention to initiate the unwinding of our APP portfolio earlier than expected by investors, bond yields will increase, especially those at  14  We consider both fully structural Dynamic Stochastic General Equilibrium (DSGE) models, semi-structural models, like NiGEM,and large macroeconometric models estimated to replicate the euro area economy. In the case of the DSGE and the macroeconometric model, we set them to reproduce the September ECB MPE projections and then consider counterfactual paths for rates, whereas in that of the NiGEM we employ its built-in projections. Agents in the DSGE model have rational expectations. NiGEM is solved both with rational and adaptive expectations. Adaptive expectations require a less aggressive response (terminal rate 1.75%) as expectations are heavily influenced by the past, characterised by a long period of below-target inflation in the euro area.
Why by raising interest rates and not by reducing the size of our balance sheet? I see three important reasons. First, we understand better the transmission mechanism of interest rate rises than that of quantitative tightening. We have decades of experience with the former, but we have never reduced the size of our balance sheet from such large levels. Second, quantitative tightening could potentially cause market turmoil in certain market segments, as supply may outgrow demand and liquidity may dry up. This could imperil the policy normalisation path at a time in which all our efforts should be focused on it. Third, monetary policy transmission in the euro area is heavily 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. Going forward, a key question is: by how much should our key interest rates eventually increase? That is, what is the value of interest rates that guarantees that inflation converges to 2% by the end of our medium-term horizon? I will call this level the “target-compatible terminal rate”. A second, related question is: how fast should this terminal rate be reached? Let me address the second question first. What should the optimal path towards the terminal rate be? One possibility would be to raise rates to the terminal level straightaway.