Can the ECB Escape Its Own Trap?
While the European Central Bank has hiked interest rates rapidly to make up ground in its fight against resurgent inflation, it is having a harder time reversing years of massive asset purchases. How can policymakers remove surplus liquidity without creating even bigger problems?
WÜRZBURG – It is now widely acknowledged that most central banks underestimated the threat of inflation when they persisted with extremely low interest rates and massive asset purchases throughout 2021 and into 2022. Fortunately, when they did finally change course, they showed remarkable determination, with the European Central Bank raising interest rates by 375 basis points in less than a year (and the US Federal Reserve raising its policy rate by 500 basis points).
But reversing the policy of massive bond purchases is proving more difficult. A decade of quantitative easing (QE) has significantly expanded the ECB’s balance sheet and created a liquidity glut, leaving policymakers in a trap from which they are struggling to escape.
The size of the ECB’s balance sheet peaked at nearly €9 trillion ($9.6 trillion) in 2022, when the volume of its bond purchases amounted to around 56% of eurozone GDP. Though it ended its net purchases of securities in July 2022, and though cuts to the subsidy that banks could earn on targeted longer-term refinancing operations (TLTROs) led them to repay large sums, the excess liquidity in the banking system still amounts to around €4 billion.
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