The European Central Bank (ECB) is currently grappling with the task of tackling inflation and needs to take swift action to reduce its inflated balance sheet. In comparison to the US Federal Reserve and the Bank of England, the ECB has expanded its balance sheet significantly more in relation to economic output. This surplus liquidity is no longer in line with the bank’s restrictive interest rate policy, necessitating a change in approach.There is some positive news for the economy and the global market. In November, the inflation rate in the Eurozone experienced a greater decline than anticipated by experts. This reduction was primarily driven by a significant decrease in service prices, resulting in an overall inflation decrease from 2.9% to 2.4%, and a decrease in core inflation (excluding volatile energy and food prices) from 4.2% to 3.6%. These developments are encouraging for citizens, and the ECB is likely to view them with relief.However, it is premature to declare victory over the “inflation monster.” November’s decline in the inflation rate may be a temporary low point, as future months could see statistical base effects counteracting further reductions. For instance, the sharp decline in energy prices from the previous year will no longer factor into the inflation rate calculation in December. Additionally, robust wage agreements throughout 2024 are expected to keep the inflation rate significantly above the ECB’s 2% target in the medium term. In fact, ECB experts currently project that average inflation in the Eurozone will still slightly exceed this target in 2025.Despite these considerations, there is ongoing discussion among market participants regarding the timing of the ECB’s first interest rate cut. The prevailing opinion within the ECB Council is that interest rates should remain high for an extended period to effectively address inflation. This approach is a lesson learned from the 1970s, when the US Federal Reserve prematurely eased its stance in the fight against high inflation, resulting in prolonged inflationary pressures. However, given the recent inflation figures, further interest rate hikes are unlikely for the time being.The ECB should now shift its focus to another aspect of its monetary policy, namely its inflated balance sheet, which is primarily composed of a massive portfolio of securities. The central bank is still investing funds from the Pandemic Emergency Purchase Program (PEPP), amounting to over 1.7 trillion euros, which is set to continue until the end of 2024. However, the excessive liquidity resulting from these purchase programs is no longer aligned with the restrictive interest rate policy of recent months.Although the ECB’s balance sheet has decreased from approximately 9 trillion euros to around 7 trillion euros, this decline is mainly attributed to the expiration of subsidized loans to the banking sector. Since March, the ECB has been gradually reducing its balance sheet, but more action is required to address the imbalance between liquidity and interest rate policy.In conclusion, the ECB is confronted with the ongoing challenge of combating inflation and should take decisive steps to expedite the reduction of its inflated balance sheet. While there have been positive developments in the Eurozone’s inflation rate, it is premature to claim victory. The ECB must prioritize addressing the imbalance between excessive liquidity and its restrictive interest rate policy.

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