ECB keeps rates unchanged but points to mounting inflation risk

The ECB has raised rates twice this year to prevent an Iran war-induced energy price jump from getting entrenched and has signalled that more may be needed, even if it was not in a hurry without evidence of dangerous second-round inflation effects.

In a decision published only hours after ECB President Christine Lagarde announced she would step down early, the ECB warned risks to inflation were skewed to the upside given a recent surge in oil and gas prices.

“Energy prices have continued to rise, posing upside risks to the inflation outlook and downside risks to the growth outlook,” the ECB said in a statement.

It added that underlying inflation had remained “broadly stable” and wages had not shown “a material response” to higher prices although “the increased magnitude and duration of the energy shock” were likely to drive up inflation and undermine growth.

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Deteriorating financing conditions, particularly in France, may complicate the bank’s next decision.

Borrowing costs have increased sharply in recent months and the flow of credit is expected to slow, putting a brake on economic growth.This achieves the sort of policy tightening an ECB hike would accomplish but also risks financial turbulence as France now has to pay a decades-high 155 basis point premium over Germany to borrow for 10 years.

“Financing conditions have tightened since the Governing Council’s last meeting, which is likely to weigh on inflation and growth,” the ECB said.

This suggests the ECB will need to walk a narrow path in the months ahead.

It must prevent high inflation from becoming embedded as price growth is already twice its 2% target. But it wants to avoid setting off turbulence in markets that could induce a recession or broader financial instability.

This is why the vast majority of economists polled by Reuters see just one or two more hikes before the ECB ends the current tightening cycle.

Attention now turns to ECB President Christine Lagarde’s 1345 GMT news conference, during which she is likely to face questions on what the ECB would do should French borrowing costs surge further.

Lagarde is also likely to be asked about her own future after saying she would leave office on February 7, months before her tenure was due to end.

Reuters reported this month that the World Economic Forum could appoint Lagarde as its next chair as soon as November, hastening a wider reshuffle at the top of the ECB.

FRENCH TURMOIL IN FOCUS

The most immediate challenge for ECB policymakers could be turmoil in bond markets.

A global rise in yields, fuelled by stronger growth expectations, higher debt issuance and massive investment linked to artificial intelligence, is pushing up borrowing costs for governments, households and businesses alike.

In France, investors have become increasingly uneasy about the country’s growing debt burden and uncertain fiscal outlook following this year’s elections. Concerns have been amplified by suggestions from parts of the political left that debt held by the ECB could be written off.

The result has been a sharp increase in French borrowing costs, with France now paying some of the highest yields in a quarter-century to raise money on bond markets.

That has fuelled speculation that the ECB might be forced to respond, if only verbally for now.

The ECB’s first line of defence would probably be flexible reinvestment of proceeds from bonds acquired during its vast asset-purchase programmes of the previous decade.

Beyond that, it could activate its never-used Transmission Protection Instrument, a scheme designed to counter what policymakers deem unjustified market pressure.