(Bloomberg) -- The European Central Bank is about to reveal its blueprint for shrinking almost €5 trillion ($5.3 trillion) of bonds — a delicate process that’s part of officials’ fight with unprecedented inflation but that also carries the danger of roiling markets.

Policymakers’ primary lever to rein in soaring prices remains interest rates, with a half-point hike expected at Thursday’s Governing Council meeting. But President Christine Lagarde and her colleagues have also promised the “key principles” for so-called quantitative tightening, which is expected to kick off early next year.

The idea is to give investors sufficient time to digest the plan, avoiding the kind of ructions that dogged Italian government debt in the summer as the ECB began raising borrowing costs after an 11-year hiatus.

Inspiration is likely to come from similar efforts by the Federal Reserve. But rolling out QT across the 19-nation euro zone — which has struggled with a debt crisis in recent years — presents a unique challenge.

Here’s what we know about the ECB’s intentions:

Roll-Offs Favored

To avert market stress, the ECB pledges a “measured and predictable” approach to reducing the stash of bonds it accumulated as economic stimulus during past crises.

That’s likely to mean allowing maturing debt to roll off its balance sheet, rather than be reinvested, like now. Letting the stock of assets shrink would remove stimulus that most agree is no longer appropriate with inflation at five times the 2% goal.

Officials want a process that can run largely in the background as they focus on rates. The precise parameters are likely to come at a meeting outside of the calendar for quarterly economic projections when major policy reassessments traditionally take place. The next is Feb. 2.

Holdings under the €3.3 trillion Asset Purchase Program have a weighted average maturity of just over seven years, with about €30 billion expiring on average each month through next November. 

Bundesbank President Joachim Nagel has said financial markets are showing “sufficient resilience” to digest a “passive rolling-off from the first quarter of 2023.” Most of his colleagues have kept it vaguer — referring only to early next year.

The way the ECB plans to implement monetary policy in the future could determine the speed and extent of its balance-sheet reduction.

Maintaining the current system where liquidity is abundant and the deposit rate is the benchmark for overnight borrowing costs would allow the ECB to retain a portion of the securities it’s accumulated. A return to the tighter conditions of the past, leaving the main refinancing rate as the guidepost, would mean offloading all of the purchases — which would take several years.

Caps, Sales

The experience of the Fed and the Bank of England may offer some pointers on QT’s design. 

In the US, more than half the portfolio is younger than five years and the Fed is capping reinvestments to gradually trim its balance sheet. In the UK, where bonds take an average of 14 years to expire, policymakers are actively selling bonds.

ECB officials’ have signaled that being “measured and predictable” could mean putting a lid on monthly roll-offs. Even Klaas Knot, the hawkish head of the Dutch central bank, has advocated an “early but partial stop” to reinvestments. 

A cap could be either a nominal amount — echoing the Fed — or a share of what’s coming due. Both could gradually rise until reinvestments cease. Piet Christiansen, a strategist at Danske Bank, says the ECB would have to a make a very soft start to QT for caps to make a material difference. 

At the other end of the scale, roll-offs can be complemented down the line by sales of longer-dated bonds, accelerating QT, though officials haven’t debated this option publicly.

What Bloomberg Economics Says...

“Given the amount of assets maturing in the coming year (nearly 1% of the APP portfolio each month on average), we don’t anticipate the ECB will need to resort to the more complex approach of actively selling bonds for now.”

—David Powell and Maeva Cousin. For full preview, click here

Fire-Fighting

Asset purchases have been a key policy pillar since 2015, restraining governments’ borrowing costs and easing fears of another debt crisis. Should their reversal spark renewed market turmoil, the ECB has tools to deal with it.

The first is redirecting reinvestments from its €1.7 trillion pandemic bond portfolio to trouble spots. There’s also the Transmission Protection Instrument, created in July to counter unwarranted shifts in yields that could endanger the transmission of monetary policy. 

Policymakers would prefer to use neither. The makeup of QT and how it’s digested by markets will determined how realistic that is.

©2022 Bloomberg L.P.