ECB Gathers With France’s Election Drama Overshadowing Future Rate Cuts

(Bloomberg) -- Officials arriving at the European Central Bank’s annual retreat in Portugal this week will struggle to escape the political drama engulfing the euro zone’s second-biggest state.

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Billed as a chance to ponder hot economic topics from a more academic vantage point, this year’s conference in the hillside resort of Sintra kicks off a day after snap elections in France that are rocking the continent just as the ECB begins lowering interest rates.

The turmoil risks overshadowing potential positive news on Tuesday in the form of a June inflation reading that’s nearer the 2% goal and may have lifted hopes that this month’s first cut in borrowing costs will soon be followed by more. Instead, concern is bubbling up over France’s fiscal trajectory and possible ECB action to calm investors.

Despite central bankers typically being hesitant to wade into national politics, “the ECB will be watching closely as it may have implications for financial markets and the transmission of monetary policy,” said Jens Eisenschmidt, an economist at Morgan Stanley in Frankfurt.

“The political developments in France and beyond will not have any impact on interest rates in the foreseeable future,” he said. “In an emergency, it will be about buying bonds to stabilize the markets. But reality is complex and so things tend to be intertwined.”

Marine Le Pen’s anti-immigrant National Rally looks set to surpass the left’s New Popular Front and Emmanuel Macron’s party to take the largest number of seats in France’s parliament, though the full picture won’t be clear until next week’s second round.

A big question is what the result will mean for spending, with the European Commission reprimanding the country less than two weeks ago for running large budget deficits. Irrespective of who wins, Bloomberg Economics foresees a clash with Brussels.

What Bloomberg Economics Says...

“Since Macron called a snap election this month, markets have been jittery. That’s not surprising. The nation’s fiscal outlook was already challenging, enough to likely trigger the EU’s Excessive Deficit Procedure. And relative to the outlook before the election was called, we think the tendency will be to borrow more, irrespective of who forms the next government.”

—Eleonora Mavroeidi and Maeva Cousin. Read the full note here.

The ECB must assess the fallout in financial markets, where the spread between French and German government-bond yields has already widened significantly — evoking Europe’s debt crisis last decade and prompting debate on whether policymakers should step in.

Officials including President Christine Lagarde say they’re monitoring the situation but haven’t witnessed the kind of disorder to justify activating the ECB’s Transmission Protection Instrument — created in 2022 to ward off undue market turbulence as rates were lifted.

“I don’t see that discussion on the TPI is topical for the moment,” Finish central-bank chief Olli Rehn told Bloomberg on Tuesday.

There may, though, already be implications for the assumptions that help underpin ECB policy. While it currently sees inflation sustainably hitting 2% toward the end of 2025 as the bloc heals after a mild recession, political uncertainty can derail or damage the economy through weak investment, according to S&P Global analyst Sylvain Broyer.

“It’s clear that the main driver will be consumer spending, which the political uncertainty is unlikely to affect,” he said. “But the recovery in investment that everybody has in mind for 2025, it could definitely be weakened.”

Indeed, Bank of Italy Governor Fabio Panetta warned last week that political uncertainty resulting from elections is a risk that must be considered alongside fragile geopolitics.

“It can trigger capital outflows and currency depreciations, creating upward price pressures,” he said in a speech. “But it could also shake confidence and weaken demand, halting or even reversing the fragile recovery we have seen so far.”

A panel discussion in Sintra, chaired by Executive Board member Isabel Schnabel, is dedicated to geopolitical shocks and their impact on inflation. Research papers presented during the week deal with the drivers of the recent surge in prices, European productivity, interest-rate cycles since the 1970s and the economics of biodiversity loss.

Tuesday’s inflation report from Eurostat may provide welcome relief, with economists anticipating a slowdown to 2.5% from 2.6% in May. Recent days have seen some officials begin to sketch out a path for one or two more rate cuts this year — broadly in line with markets current thinking.

Lagarde, who’ll open the forum with a dinner speech on Monday and appear alongside Federal Reserve Chair Jerome Powell the following day, has warned of “bumps in the road” as price gains return to target. Chief Economist Philip Lane says officials must be “agile” in responding to surprises.

  • Follow Tuesday’s TLIVE blog on Lagarde and Powell here

For Claudia Panseri, chief investment officer for France at UBS, Europe’s election jitters aren’t the key focus.

“The ECB will be watching CPI more than the political issue,” she told Bloomberg TV. “Clearly the ECB needs to cut rates. There is some recovery in the economy, but we still see that this recovery is pretty shy.”

--With assistance from Tom Mackenzie.

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