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Over the past two years, inflation in the euro area has surged significantly, and despite recent deceleration, it continues to remain excessively rapid. Consequently, the European Central Bank (ECB) has notably tightened its monetary policy. The policy rates have been raised by 4.25 percentage points, and the ECB's key deposit rate for banks stands at 3.75 percent. "The current scale of monetary policy restrains economic growth and hampers inflation.

The latest available data are emphasized in the ECB's decision-making to ensure that the deceleration of inflation towards the target does not delay excessively or lead to unnecessary contraction of overall demand," says Tuomas Välimäki, a member of the Board of the Bank of Finland.

Simultaneously, as policy rates have been increased, the ECB has significantly reduced the volume of securities holdings and loans extended to banks. "With the reassertion of interest rate control in the center of monetary policy, the Eurosystem's balance sheet can be gradually and predictably downsized. However, the ECB remains prepared to respond to adverse market tensions, whether in government bond or money markets," adds Välimäki.

As the Eurosystem's holdings of securities and loans to banks decrease, the level of reserves, i.e., bank deposits with the central bank, diminishes. With this development, short-term money market rates will eventually begin to rise from deposit rates towards the rate of main refinancing operations. Before such a transition occurs, the ECB is considering how to conduct monetary policy in the future. "Harmful interest rate volatility could potentially be mitigated by narrowing the difference between lending and deposit rates," notes Välimäki.

Many mechanisms in the economy and financial markets have substantially transformed over the last 15 years. Changes have been triggered by factors like the natural decrease in the neutral interest rate, high indebtedness, fragmentation risk in the euro area's financial markets, and increased liquidity needs of banks. Additionally, central bank balance sheets have grown, and their composition has shifted. "It's not evident that the pre-financial crisis method of guiding interest rates will be effective or even possible in the future," says Välimäki.

Despite contraction, the Eurosystem's balance sheet is likely to remain considerably larger due to the growth in demand for banknotes and reserves. This might necessitate structural measures to ensure an adequate level of reserves. Such measures could involve longer-term credit operations for banks or market-based securities purchases. "A structural credit operation might have characteristics that enhance financial stability. A structural securities portfolio, on the other hand, would improve the ECB's ability to undertake concrete actions in the fight against climate change," Välimäki adds.

Monetary policy will continue to be executed in a context of high uncertainty. Therefore, the employed arrangements must remain flexible. "The Eurosystem must be capable of tightening and loosening financing conditions in all circumstances in a manner required by the price stability objective," emphasizes Välimäki.