Euro area inflation has been above the European Central Bank’s (ECB) price stability target over the past two years, and despite a recent decline in inflation, it remains too high. In response, the ECB has tightened its monetary policy considerably. The key ECB interest rates have been raised by a total of 4.25 percentage points, and the deposit facility rate is now at 3.75%. “The current monetary policy stance is restricting economic activity and slowing inflation down. The latest available data is playing a key role in the ECB’s decision-making, the aim being to avoid too slow a decline in inflation or an unnecessarily strong decline in aggregate demand,” says Member of the Board of the Bank of Finland Tuomas Välimäki.

At the same time as the ECB has raised its key interest rates, it has allowed its securities holdings and the volume of credit granted to banks to wind down significantly. “Interest rates have returned to the focus of the ECB’s monetary policy, which means the Eurosystem balance sheet can be reduced gradually and as predictably as possible. The ECB nevertheless stands ready to react to harmful market tensions in the government bond or money markets,” says Välimäki.

With the decrease in the Eurosystem’s securities holdings and loans to banks, there is a decline in the volume of banks’ deposits with the central bank (i.e. reserves). A continued decrease in these deposits means that short-term money market interest rates will, in due course, begin to rise from the deposit facility rate towards the main refinancing operations rate. Before this, however, the ECB is reviewing the options for implementing monetary policy in the future. “Potentially damaging volatility in money market rates can be avoided by, for example, narrowing the gap between the ECB’s lending and deposit rates,” says Välimäki.

Many of the operating mechanisms in the economy and in the financial markets have changed fundamentally in the past 15 years. These changes have been driven by factors such as the fall in the natural rate of interest, the high level of indebtedness, the fragmentation risk in the euro area financial markets, and the growing liquidity needs of banks. Central bank balance sheets have also expanded and their composition has altered. “It’s not clear whether, in the future, the pre-financial crisis approach to controlling money market rates would be effective or even possible,” notes Välimäki.

The Eurosystem balance sheet, despite its shrinking, might remain significantly larger than it was before, due to factors such as the increase in banknotes in circulation and in the demand for reserves. This could call for structural measures to ensure sufficient reserves. Such measures could include longer-term refinancing operations for banks or securities purchases in the markets. “Structural refinancing operations could help to enhance financial stability. And a structural securities portfolio could improve the ECB’s scope for continuing concrete measures to combat climate change,” Välimäki adds.

In the future, too, monetary policy implementation will take place amid great uncertainty. Policy implementation arrangements will therefore need to remain flexible. “The Eurosystem will have to be able to tighten and loosen financing conditions under all kinds of circumstances, and in a manner consistent with the price stability objective,” emphasises Välimäki.