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The European Central Bank is expected to leave its three main policy rates unchanged at its 29 October meeting, after raising them by 25 basis points in September, as it weighs still-high inflation against signs of weakening growth.

Rising energy costs linked to developments in the Middle East, higher government bond yields in Europe and political and fiscal uncertainty in France have complicated the picture, with analysts saying a further rate increase is most likely in December, when the bank also publishes new projections.

Markets look to a cautious hold

Economists expect the ECB to stay cautious and keep rates steady this month, while market pricing points to a possible increase in December. Borrowing costs in European bond markets have been climbing, and political and fiscal uncertainty in France has raised questions about what additional tightening would mean for economic activity.

Higher energy costs in Europe have made the trade-off harder for the bank as it tries to fight inflation without weakening demand. The ECB raised its three main policy rates by 25 basis points at its September meeting.

Inflation climbs while growth data awaits

Annual inflation in the euro area rose to 3.8% in September this year, driven by higher energy prices. The bloc's economy expanded 0.6% in the second quarter compared with the previous quarter, and the third-quarter growth reading is due to be released on Friday.

Energy prices have also come under pressure from geopolitical developments in the Middle East, adding to uncertainty over the inflation outlook.

Analysts see a pause, not a full stop

ING Group Chief Economist Peter Vanden Houte told Anadolu Agency (AA) that "inflation is still very high and could accelerate a bit further in the coming months." Vanden Houte also cited ECB President Christine Lagarde as saying that growth has remained resilient but long-term interest rates have risen significantly since the last meeting, which will slow growth and damp the pass-through of rates to inflation more than the September forecasts assumed.

Vanden Houte said recent turmoil in France has widened bond yield spreads between countries facing serious fiscal problems, including France, Belgium and Italy, and expects the ECB to hold rates this month and wait until December to assess developments more fully. The bank will publish fresh economic forecasts at that meeting. Vanden Houte said another increase cannot be ruled out, though not this month, and that if bond markets remain unsettled the ECB could consider pausing quantitative tightening temporarily and reinvesting proceeds from maturing bonds flexibly.

Bond stress and possible policy tools

Rabobank Senior Macro Strategist Bas van Geffen said the ECB has no reason to speed up rate increases. Inflation remains the bank's main worry, but current conditions do not call for an immediate move, Geffen said, adding that "financial conditions have tightened somewhat, partly because of the turmoil in French bond markets, which could lead the ECB to adopt a more dovish tone at the press conference."

Geffen said yield spreads between countries are not at levels that would require intervention, though Lagarde may remind markets of the tools the ECB can use to limit spillovers. The bank could consider raising the reserve requirement ratio, Geffen said, but recent market turbulence may keep the Governing Council from making such a change.

Berenberg Chief Economist Holger Schmieding said the surge in energy prices and rising risks linked to France are putting pressure on the ECB. Facing two shocks at once, the bank is expected to keep rates unchanged, but Schmieding does not expect them to stay there for long. Schmieding said the rise in annual inflation to 3.8% in September, its highest level in three years, points to a possible renewed increase, and that the most likely scenario is a further hike at the 17 December meeting, after rates are left unchanged on 29 October and new staff projections on growth and inflation are released. Schmieding expects no change in the pace of the ECB's balance sheet reduction, even if financial risks from France come to the fore.

Key takeaways

• The ECB is expected to hold its three main policy rates at the 29 October meeting after a 25 basis point increase in September.
• Euro area inflation rose to 3.8% in September on higher energy prices, while the economy grew 0.6% in the second quarter.
• ING, Rabobank and Berenberg economists see no move this month, with a December increase considered the most likely scenario.
• Bond market turmoil and French fiscal uncertainty may push the ECB toward a softer tone and more flexible reinvestment of maturing bonds.