ECB Transitions to New Normal as Balance Sheet Shrinks

The European Central Bank (ECB) is transitioning towards a new normal in its financial environment. In recent years, the ECB has reduced its footprint in the market by shifting back to conventional monetary policy and withdrawing forward guidance.

This change is evident in interest rates. Sovereign yields in major euro area economies have returned to pre-2008 global financial crisis levels. Meanwhile, investors are demonstrating a capacity for discrimination, with positive risk premiums consistent with countries' macroeconomic fundamentals, even after the Middle East energy shock.

The ECB's balance sheet has also shrunk from a peak equivalent to 65% of the euro area's GDP in 2021 to fluctuate around 37%, a level comparable to that of 2017. This reduction was facilitated by the withdrawal of liquidity previously injected during times of crisis, following the end of exceptional loans to the financial sector and the passive winding down of debt purchased under QE programmes.

The ECB aims for agile decision-making, meeting by meeting, based on economic and geopolitical data and events. It has paired the return to normality of its monetary tools with a reform of its operational framework to ensure that the liquidity drain does not compromise monetary policy implementation in the future.