One is that it could jeopardise central bank’s credibility by giving rise to accusations of financial and fiscal dominance. A second side effect is that maintaining a larger balance sheet than necessary increases the Eurosystem’s exposure to credit and duration risk. The probability and extent of net losses are significantly higher the larger the amount of long-term fixed-rate assets the central bank holds on its balance sheet. [7] A third side effect relates to the functioning of financial markets. The APP, together with the pandemic emergency purchase programme (PEPP), has left a visible footprint in euro area financial markets. The Eurosystem’s outright holdings of euro area sovereign bonds currently amount to more than a third of the outstanding market (Slide 3). Mobilised collateral for longer-term refinancing operations further increases the encumbrance of government bonds through monetary policy operations. As a result, the “scarcity premium” that market participants must pay to obtain these assets has often been considerable, both in the repo and the bond market (Slide 4). [8] The inception and expansion of the Eurosystem’s securities lending facility have been able to partly alleviate these strains. [9] Yet, in times of heightened uncertainty, when the demand for safe and liquid assets rises sharply, market conditions tend to visibly deteriorate. Last year’s surge in market volatility is a case in point.
Reducing the size of our balance sheet is warranted for three reasons: first, to regain valuable policy space in an environment in which the current large volume of excess liquidity is not needed for steering short-term market interest rates; second, to mitigate the negative side effects associated with a large central bank balance sheet and footprint in financial markets; and third, to withdraw policy accommodation to support our intended monetary policy stance. I will then explain the effects of the reduction of our balance sheet on broader financial markets. While QT will not simply be a reversal of QE, investors anticipating balance sheet run-off are likely to have gradually reversed some of the risk premium compression induced by our asset purchases, thereby contributing to the timely return of inflation to our 2% target. Why quantitative tightening? Let me start by discussing the rationale for QT in more detail. Regaining policy space when excess liquidity is higher than needed The first reason relates to the ECB’s operational framework. After the start of the APP in 2015, we de facto moved from a corridor system for steering short-term market rates towards a floor system, as the large increase in excess liquidity caused money market rates  to converge to the rate applied by the Eurosystem to its deposit facility (the deposit facility rate, or DFR; Slide 2). [4] In the ongoing review of our operational framework, we are analysing whether in the future we will operate under a floor or a corridor system.