Name: Belgian Financial Forum
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10/12/2025

quantitative easing quantitative tightening balance sheet normalisation credibility risks

This study investigates the ECB’s unprecedented quantitative tightening, analysing its underlying rationale, implementation challenges, and financial market effects. QT seeks to restore policy space and reinforce institutional credibility, yet its transmission and optimal design remain uncertain. Event-study evidence indicates that QT announcements led to significant increases in sovereign yields, while effects on other asset classes were limited.

Research motivation

The ECB’s initiation of quantitative tightening (QT) marked a new and unprecedented stage in the history of the bank. For almost a decade, the ECB pursued large-scale asset purchases through the Asset Purchase Programme (APP) and the Pandemic Emergency Purchase Programme (PEPP), aiming to sustain highly accommodative financial conditions in response to successive crises. These measures fostered an environment of abundant liquidity and persistently low long-term interest rates, fundamentally reshaping the euro area’s financial landscape.

In 2022, confronted with soaring inflation and the need to re-establish price stability, the ECB reversed course and began, for the first time in its history, a deliberate and gradual reduction of its portfolio. This transition marks not merely a policy adjustment, but a structural reversal of expansive balance sheet policies that had defined the previous decade. Notably, balance sheet reductions in nominal terms, where the aggregate size of a central bank’s assets decline, are exceedingly rare in global monetary history. Consequently, the macroeconomic and financial repercussions of liquidity withdrawal remain insufficiently understood and empirically underexplored.

This master’s dissertation aims to fill this gap by examining the rationale behind the ECB’s balance sheet normalisation, the challenges associated with its implementation, and the early evidence of its effects on financial markets. By analysing this unprecedented phase of policy tightening, this research contributes to a deeper understanding of how liquidity withdrawal may influence financial stability, market functioning, and the transmission of monetary policy in the euro area.

The Justifications of the Balance Sheet Reduction

The decision to reduce the size of the central bank’s balance sheet wasn’t straightforward, as conventional monetary policy, via interest rate changes, does not necessarily require a leaner balance sheet. This master’s thesis identifies five justifications for a reduction.

1. Scaling back the impact of asset holdings

The post-pandemic stance of the ECB’s balance sheet has left a lasting mark on financial markets. The extensive bond holdings accumulated under APP and PEPP continued to exert downward pressure on long-term yields by compressing the term premium, an effect commonly referred to as the stock effects of quantitative easing. This residual accommodation weakens the transmission of the policy rate increases that started in 2022, thereby maintaining more expansionary financial conditions than intended by the ECB. By allowing securities to mature without reinvestment, the ECB’s quantitative tightening process gradually alleviates this downward pressure on long-term yields, contributing to a steeper yield curve and enhancing the overall effectiveness of monetary tightening in addressing the post-pandemic surge in inflation.

2. Normalising asset valuations

Prolonged periods of abundant liquidity and historically low interest rates have contributed to pronounced increases in equity, bond, and housing valuations, often exceeding levels consistent with underlying economic fundamentals. By reversing these exceptionally accommodative financial conditions, QT can facilitate a gradual realignment of asset prices with their theoretical fundamentals, thereby mitigating the risks of market distortions and speculative behavior.

3. Restoring policy space

Maintaining an enlarged balance sheet constrains the ECB’s capacity to employ balance sheet instruments in response to future crises. Beyond the finite supply of eligible securities, the ECB has established self-imposed issuer and issue limits to prevent excessive market dominance. Without a reduction in its market footprint through the roll-offs of maturing assets, these thresholds could be reached swiftly, restricting the ECB’s ability to reinitiate QE when warranted. By unwinding the substantial holdings accumulated since 2015, the central bank creates renewed space to deploy asset purchases as a countercyclical tool in the future.

Moreover, the influence of the ECB’s bond portfolio on market pricing is inherently constrained. A persistently large balance sheet exerts downward pressure on the term premium. This residual effect diminishes the marginal effectiveness of future QE, as long-term yields are already compressed. A leaner balance sheet thus restores essential policy space, ensuring that balance sheet instruments remain an effective component of the ECB’s monetary toolkit.

4. Reducing collateral scarcity

Quantitative easing has absorbed a substantial share of the high-quality sovereign bonds, particularly those serving as collateral in repo markets. This absorption has contributed to collateral scarcity, leading repo rates for certain securities to fall below the deposit facility rate (DFR), the theoretical floor for money market rates in an environment of ample liquidity. This phenomenon, known as specialness, is noteworthy given the repo market’s central role in providing short-term funding and facilitating monetary transmission. Persistently low repo rates relative to the DFR imply a more accommodative monetary stance than intended. Consequently, a gradual reduction of the ECB’s balance sheet can help alleviate collateral shortages, enhance market liquidity, and strengthen the transmission of tighter monetary policy.

5. Safeguarding credibility and independence

Persistently large holdings of government bonds risk blurring the distinction between monetary and fiscal policy, raising concerns about fiscal dominance and indirect monetary financing. Implementing QT underscores that balance sheet measures are temporary and reversible, thereby reinforcing the ECB’s independence and its commitment to price stability.

Moreover, recent research questions the appropriateness of prolonged QE. While asset purchases may be justified ex ante in periods of inflation undershooting and output nearing potential, even modest fiscal or macroeconomic shocks in a liquidity-saturated environment could amplify inflationary pressures.

Finally, the ECB’s expanded balance sheet has exposed it to valuation losses as interest rates have risen. Although solvency concerns remain remote, sustained losses or heightened fiscal interdependence could undermine institutional credibility and invite political interference. Gradual balance sheet reduction mitigates these risks and supports the banks’ financial independence.

The Challenges of Quantitative Tightening

The rationale for balance sheet normalisations must be carefully weighted against several inherent challenges. As noted in the introduction, the reduction of the central bank’s holdings is characterised by significant uncertainty, given the scarcity of empirical evidence and the limited number of historical precedents to guide decision-making. The following section therefore examines the principal challenges associated with the process of balance sheet reduction.

1. The path towards the optimal balance sheet

At the outset of balance sheet normalisation, central banks faced a strategic choice between a rapid adjustment and a gradual, more predictable approach. On one end of the spectrum, the ECB could have maintained a nominally stable balance sheet, allowing it to shrink only relative to GDP. While this strategy minimises market repricing and enhances predictability, it offers little genuine normalisation, as slow GDP growth would produce a “ratchet effect” that limits the recovery of policy space. At the other extreme, active QT through outright asset sales could induce financial volatility and should only be pursued under stable market conditions. In practice, the ECB has adopted a path broadly consistent with the “textbook” normalisation cycle illustrated in figure 1: a gradual and well-communicated process designed to minimise disruptions. Ultimately, the pace and scope of QT remain contingent on macroeconomic conditions. Given the state-dependent and still uncertain effects of QT, the ECB must retain flexibility to slow, pause, or reverse the process if warranted by evolving financial or economic developments.

2. The size of the optimal balance sheet

Determining the “optimal” size of a central bank’s balance sheet is not an exact science, as no theoretical framework clearly defines the appropriate level of central bank reserves. However, in the literature, there has been a well-established stylized fact that there is a negative relationship between system-wide liquidity and interest rate volatility, implying that abundant reserves play a stabilising role, whereas excessive balance sheet reduction can heighten market volatility. This was illustrated by the U.S. money market turbulence in September 2019, when declining reserves, driven by the Fed’s balance sheet reduction, triggered sharp and unexpected spikes in short-term rates. For the ECB, this underscores the importance of accurately assessing the structural demand for liquidity when determining the appropriate balance sheet size. Liquidity needs are now structurally higher than before the global financial crisis, reflecting tighter regulatory requirements under frameworks such as Basel III. Consequently, reducing the balance sheet to pre-crisis levels could be destabilising. The optimal size should therefore be sufficiently large to meet banks’ ongoing liquidity requirements while maintaining a buffer to absorb short-term fluctuations in funding demand.

3. Challenges to monetary policy effectiveness

Recent research indicate that large-scale asset purchases have contributed to the decline in the natural rate of interest (r*), thereby influencing the transmission of policy rates to the broader economy. These studies highlight the dynamic interaction between the supply and demand for safe assets, captured by the convenience yield (i.e. the premium investors are willing to pay for the liquidity and safety of these assets) as a key indicator of r*. Consequently, when the ECB reduces its asset holdings, the supply of safe assets rises, which reduces the convenience yield and, in turn, raises the neutral rate. This mechanism implies that the effects of quantitative tightening (QT) may be less contractionary than initially anticipated. Analogous to ascending a hill whose summit recedes as one approaches, this process complicates the central bank’s assessment of its policy stance. Isabel Schnabel, Executive Board member of the ECB, refers to this phenomenon as the “convenience yield channel,” which can obscure the true impact of monetary policy.

4. Fragmentation risks in the euro area

The Eurosystem’s unique structure poses additional challenges for balance sheet normalisation. According to the theory of optimal currency areas, member states experiencing asymmetric shocks cannot all be adequately supported by a uniform monetary policy. In the euro area, differences in economic structures, fiscal capacity, and monetary transmission can amplify the uneven effects of ECB policy withdrawal. As the ECB reduces its bond holdings, markets reassess the creditworthiness of weaker sovereigns, raising refinancing costs and potentially reigniting the “sovereign-bank nexus”, whereby fiscal stress undermines domestic banking sectors. To mitigate these risks, the ECB has conducted balance sheet roll-offs flexibly, occasionally deviating from the Eurosystem’s capital key, and introduced the Transmission Protection Instrument (TPI) to address “unwarranted” increases in financing costs via secondary market purchases. While TPI eligibility is subject to cumulative conditions, including the absence of an excessive deficit procedure, the ECB has emphasized that these criteria are guidance rather than strict constraints, raising concerns about potential impacts on the banks’ independence.

Event study analysis

The empirical analysis in this dissertation investigates financial market reactions to ECB quantitative tightening announcements using a standard event-study methodology. This approach assesses how asset prices respond to policy events by analysing market movements. Specifically, the study examines the impact of ECB balance sheet policy announcements on sovereign yields, corporate bond indices, equity indices, and exchange rates. The dataset comprises daily observations from Refinitiv Datastream spanning January 2021 to May 2025, covering nine major QT-related events, for instance including the 16 December 2021 decision to end PEPP net asset purchases by March 2022. To isolate the effects of QT, the analysis controls for unexpected policy rate changes and surprise economic data releases.

Figure 2 presents baseline regression estimates, showing that QT announcements led to statistically significant increases in sovereign yields across all maturities, with the strongest responses in the 2–10-year segment. For instance, 2-year yields rose on average by 6.6 basis points following QT announcements. Findings in the paper further show that the effects were most pronounced during early QT communications, likely reflecting the novelty of QT at the time. Overall, the cumulative impact on sovereign yields ranged from approximately 30 bps at short and long maturities to 60 bps at medium maturities. These results suggest an asymmetric response compared with quantitative easing episodes, which saw stronger reactions from markets. This asymmetry may be attributed to the ECB’s more gradual approach to QT and the calmer market environment in which it was implemented.

The analysis further explores whether QT announcements affect market perceptions of euro area fragmentation risk by examining sovereign yield spreads relative to German Bunds. As shown on the right side of Figure 2, QT announcements are associated with a small, statistically insignificant widening of spreads, indicating a modest increase in perceived fragmentation risk. This effect is somewhat stronger for lower-rated sovereigns, which exhibited larger spread responses than higher-rated counterparts.

Equity market reactions, measured using the STOXX 50 and other broad indices, reveal minor and statistically insignificant declines following QT announcements, with the largest responses occurring during the initial phase of the process.

Overall, QT announcements appear to tighten financial conditions primarily through higher sovereign yields, with insignificant effects in other asset classes. Market sensitivity was greatest early in the QT cycle, when announcements carried higher informational content. As the ECB’s communication improved and the QT path became more predictable, announcement effects diminished. These results suggest that QT operates as a gradual and well-managed normalization tool, consistent with the ECB’s intent to maintain market stability. In this sense, the findings align with Janet Yellen’s characterization of balance sheet normalization as “like watching paint dry,” reflecting QT’s passive and background role within the ECB’s broader monetary policy framework.