ECB Seen Holding Rates Amid French Bond Market Stress, With Another Hike Possible in December

The European Central Bank is set to leave interest rates unchanged as it weighs stress in France’s government bond market and inflation pressure from higher energy prices.

Bloomberg reported on October 29 that the ECB is expected to keep its deposit rate at 2.5% at its monetary policy meeting later in the day. Most economists in a Bloomberg survey projected no change, while also anticipating one additional rate increase in December.

Inflation in the euro area has climbed to nearly double the ECB’s 2% target. Still, price pressures are concentrated mainly in energy, giving policymakers room to tread cautiously on further tightening. Disruptions to oil and natural gas supplies linked to the war in Iran are a key variable for the inflation outlook.

Stress in France’s sovereign debt market is also weighing on the ECB’s rate decision. French bond yields have surged as a widening fiscal deficit, political divisions and social unrest converge. The spread between French and German 10-year government bond yields has recently widened to its highest level in 15 years, raising the possibility that market anxiety could spread to other euro-area countries including Italy.

Bloomberg Economics economists David Powell and Simona Delle Chiaie said the ECB is likely to keep rates unchanged at this meeting because higher borrowing costs have already tightened financial conditions, while instability in the bond market gives policymakers reason to avoid moves that could worsen the situation.

Markets are also watching whether the ECB will deploy policy tools to stabilize the bond market. In 2022, the central bank introduced the Transmission Protection Instrument, or TPI, which allows potentially unlimited purchases of government bonds to counter disorderly market moves. Even so, applying the tool to France’s fiscal problems may not be straightforward. Nanette Hechler-Fayd'herbe, chief investment officer at Lombard Odier, said the ECB is unlikely to use the TPI unless disruption spreads across the broader euro-area financial system.

The ECB is expected to decide whether to raise rates again based on new economic projections due in December. ECB President Christine Lagarde has maintained that a gradual adjustment in monetary policy is appropriate. Investors see euro-area third-quarter growth data and October inflation readings from major economies, due on October 30, as key indicators for the future path of rates.