ECB set to hold rates despite inflation and French bond market turmoil

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ECB set to hold rates

Highlights

ECB expected to hold rates at 2.5%.
Energy inflation approaches 4%.
French bond turmoil complicates ECB policy.

The ECB is widely expected to maintain its deposit rate at 2.5%, with nearly all economists surveyed anticipating no change. Bloomberg reported that analysts expect a final rate increase in December, when updated economic forecasts will provide a clearer assessment of inflation through 2028.

Energy prices complicate the inflation outlook

Eurozone inflation is approaching 4%, nearly twice the ECB's 2% target, as the conflict involving Iran continues to disrupt oil and gas supplies. However, price pressures remain concentrated in energy, allowing policymakers to assess whether higher costs are spreading into wages, services, and other consumer prices before committing to another increase. ECB President Christine Lagarde and other members of the Governing Council have favored gradual adjustments, particularly as higher borrowing costs begin to slow economic activity.

A pause in October followed by a December increase would maintain the recent quarterly pace of monetary tightening without placing additional immediate pressure on businesses and households. The ECB will also receive important economic data Friday, including third-quarter eurozone growth figures and October inflation reports from its four largest economies. These releases could help determine whether inflation is becoming more persistent or whether weakening demand will limit further price increases.

French bond market turmoil raises financial stability concerns

France has become a major source of uncertainty for European financial markets as its budget deficit, political divisions, and social unrest undermine investor confidence. The yield spread between French and German 10-year government bonds recently reached its widest level in 15 years, while signs of pressure spreading to Italian debt have raised concerns about broader financial instability. Higher sovereign borrowing costs could further weaken investment and growth across the eurozone, even as they help restrain inflation.

The ECB has instruments designed to address disorderly market conditions, including the Transmission Protection Instrument introduced in 2022. However, these measures are not intended to protect governments from the consequences of excessive deficits, and policymakers have shown little willingness to intervene. Suspending the gradual reduction of the central bank's bond holdings is another possibility, although there is currently no indication of sufficient support for such a move.

Investors await Lagarde and the December policy decision

Investors will examine Lagarde's comments for indications of whether French bond volatility could affect the ECB's willingness to raise rates again. Uncertainty surrounding her future has also attracted attention after she acknowledged considering an early departure before her term expires next October.

The December meeting is emerging as a crucial test of the ECB's policy direction. Another increase could strengthen its response to inflation but would also raise financing costs for governments, companies, and households at a time when economic growth is slowing and financial markets remain vulnerable.

We have previously highlighted that Warsh keeps the December rate hike in play.

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