Ready for a French test?: Five questions for the ECB

The European Central Bank (ECB) is set to meet on Thursday amidst unrest in France and geopolitical tensions in Iran, which have driven energy prices above $100, keeping inflation risks high. ECB head David Coombs noted that determining interest rates in this environment is incredibly challenging.

Anticipation is growing for a pause in interest rate hikes, following the ECB's rate increases in June and September to combat inflation. Unchanged at 2.5%, the key interest rate is expected to remain steady after the recent hikes. However, economists remain cautious, with MUFG senior economist Henry Cook stating that they do not believe inflation concerns have diminished significantly.

The ECB is likely to continue a data-dependent approach when discussing future rate outlooks. With high inflation at 3.8% in September and concerns over rising government bond yields, policymakers have advocated for a measured response to avoid exacerbating inflationary pressures. Barclays' head of euro rates strategy, Rohan Khanna, emphasized the need to signal tightening financial conditions and their potential impact on economic growth.

While the ECB appears less concerned about the inflationary impact of high energy costs at present, the organization remains vigilant. ECB chief economist Philip Lane's comments suggest that the institution is monitoring the situation closely. Core inflation, which excludes volatile food and fuel prices, has only mildly increased to 2.5% from 2.4% last month, indicating that energy cost pressures have yet to trigger widespread inflationary effects.

Despite this, the ECB is likely to maintain a cautious stance, particularly if the Iran conflict escalates or if energy prices continue to surge. Bas van Geffen, senior macro strategist at Rabobank, warns that should the war in Iran intensify, or if energy prices remain volatile, the ECB may still be compelled to raise rates in 2027.

French 10-year borrowing costs have reached 24-year highs, exceeding 5%, amid political instability and violent protests. The premium investors require for French bonds over German bonds has widened to 170 basis points, up from 92 basis points during the last ECB meeting. However, the ECB is unlikely to act hastily, particularly if France's fiscal situation remains a priority to avoid broader economic contagion.