The eurozone is now in a new era of monetary policy normalization. So far, the European Central Bank (ECB) has scaled down its asset purchase program to €30 billion per month until September. It also says it will keep interest rates low "well past the horizon of our net asset purchases," but hasn't yet outlined further actions. In terms of sequencing, we think the ECB will find it helpful to look at the U.S. Federal Reserve: taper first, raise interest rates later, and reduce the balance sheet when rates are in comfortable territory.
The Fed's Blueprint For Sequencing
Tapering before raising rates makes sense, based on the interactions between quantitative easing (QE) and rates. Asset purchases not only ease financial conditions by compressing bond yields, but show a commitment to keeping rates low for longer, absent a zero lower bound in the eurozone. By first ending the asset purchase program, the ECB can break this link and signal future rate rises.
The next step will be to raise interest rates while operating with a stable balance-sheet size. The key reason why the Fed proceeded in this order also applies to the eurozone. While setting interest rate policy is straightforward, there is much uncertainty regarding the impact of unconventional monetary policy measures on financial conditions. Bringing interest rates higher allows the central bank some leeway to cut them if financial conditions tighten too much when it starts shedding assets (see Bernanke on "Shrinking The Fed's Balance Sheet" Brooking, Jan. 26, 2017).
As a third step, the ECB will start reducing its balance sheet. We think it is important to do this in a passive manner to facilitate monetary policy communication. Therefore, like the Fed, the ECB will likely stop reinvesting maturing securities holdings, but not actively sell assets. In this way, balance-sheet reduction is predictable. Markets can estimate the degree of policy tightening implied by the balance-sheet reduction and draw conclusions on interest-rate setting. From what we've observed in the U.S., this approach has helped prevent sudden tightening of financial conditions, in contrast to the "taper tantrum" of 2013.