ECB Faces a French Test as Energy Shock and Bond Selloff Complicate Thursday's Rate Decision

The European Central Bank sits down on Thursday to decide on interest rates with two pressures bearing down at once: political and financial upheaval in France, and an Iran war that is holding energy prices above $100. Inflation risks remain elevated. As David Coombs, head of multi-asset investments at Rathbones Asset Management, put it, setting rates against that backdrop is "incredibly difficult."

The expected outcome is a pause. The ECB is widely anticipated to leave its key rate at 2.5%, after raising it in both June and September to counter inflation driven by the war's effect on energy costs. A pause is not the same as a pivot, though. Economists polled by Reuters expect a quarter-point hike in December. MUFG senior economist Henry Cook said he does not think policymakers have become materially less worried about inflation.

On guidance, the bank will likely keep to a data-dependent approach. Headline inflation stood at 3.8% in September, well above the 2% target, while rising government bond yields raise concern about growth. Policymakers have recently argued for what President Christine Lagarde called a "measured response." Rohan Khanna, Barclays' head of euro rates strategy, expects a clear nod to tighter financial conditions and how they should slow growth and curb inflation, alongside plenty of uncertainty about the conflict and the energy outlook.

Officials such as chief economist Philip Lane have signaled the bank is not overly worried, for now, that high energy costs will spill into other prices and wages. Core inflation, which strips out food and fuel, edged up to 2.5% last month from 2.4%, a muted move suggesting the second-round effects that can start a hard-to-break spiral have not yet appeared. Still, oil is up almost 80% this year, and the ECB is likely to stress vigilance. Bas van Geffen, senior macro strategist at Rabobank, said further escalation or energy pressure could mean more hikes in 2027, though he has none penciled in. Markets price in at least two hikes by mid-2027.

France is the new complication. Its 10-year borrowing costs have just reached 24-year highs above 5%, while a weakened government faces violent protests that could undermine efforts to repair fragile finances. The premium investors demand to hold French 10-year bonds over German ones is 170 basis points, up from 92 when the ECB met last month. The ECB is watching, but a quick move is not expected on the Transmission Protection Instrument, which lets it buy the bonds of any member state facing an "unwarranted, disorderly" tightening of financing conditions. Lagarde says France should solve its debt problems through fiscal consolidation.

Berenberg chief economist Holger Schmieding said the ECB could hold back on hikes if it thinks a French crisis would materially hurt growth. And if serious contagion spread to countries with more sustainable fiscal policy, he said, the ECB would probably use the TPI to shield those countries, not France.

Lagarde will likely also be pressed on succession. She could be appointed the next World Economic Forum chair as early as November. Klaas Knot and Pablo Hernandez de Cos, the former central bank governors of the Netherlands and Spain, are seen as frontrunners to replace her. Her exit would open a second vacancy on the ECB's six-member Executive Board, following Isabel Schnabel's recent resignation, and Lane is due to step down in May. Lagarde's term runs to next October; leaving early would leave time to pick a successor before France's spring presidential election. Analysts say a snap Spanish election could also affect the politics of the succession.

Thursday's decision itself looks settled. What to watch is the language around December, any sign on the TPI, and what Lagarde says about her own future.