Weekly Update - Central banks: The balance sheet, the other monetary policy tool

As markets closely watch the upcoming central bank meetings next week, attention naturally focuses on key interest rates. But behind this classic lever lies another dynamic, quieter yet just as decisive: balance sheet policies. These may evolve with potentially contrasting paths between the Federal Reserve (Fed) and the European Central Bank (ECB).

Few surprises are expected regarding key interest rates. In the United States, a 25 basis point cut is widely anticipated, bringing Fed rates down to 3.75–4.00%. This decision would follow a monetary easing path restarted in September, which we believe will continue with another cut by the end of 2025. However, resilient economic activity and persistent inflationary pressures should then prompt the Fed to remain cautious. This stance contrasts with money market expectations, which factor in two additional cuts by mid-2026.

In the eurozone, the ECB is expected to keep rates unchanged at 2.00%, in line with its recent communication. In the short term, disinflation could accelerate due to falling oil prices, a stronger euro, and slowing service inflation. But in the medium term, fiscal stimulus plans, notably in Germany, could revive price pressures. In this context, we anticipate a prolonged status quo, with a possible additional cut if the economic outlook temporarily worsens.

Balance sheet policies: the Fed may stop before the ECB. Beyond key rates, balance sheet policies—from quantitative easing (QE) to quantitative tightening (QT)— deserve increased attention. They operate through central banks’ purchases or sales of financial assets, directly influencing long-term financing conditions. After massively expanding their asset portfolios during the Covid crisis - the Fed and ECB doubled their balance sheets - both institutions have begun gradual reductions. While balance sheets remain large in absolute terms, their relative share in public debt holdings has already significantly declined. The Fed now holds less than 15% of U.S. public debt, close to its pre-Covid level. It could therefore slow down or even suspend its QT soon. Conversely, the ECB still holds over 25% of eurozone sovereign debt. Projecting the current pace of reduction, it could maintain QT until the end of 2026.

This divergence could have contrasting effects on long-term rates: in the U.S., the end of QT could moderate them, while in the eurozone, continued balance sheet tightening could instead keep upward pressure.

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