(Bloomberg) -- European Central Bank officials long used to navigating troubling times for the world now face a headache far closer to home: a leadership crisis at the heart of the euro zone itself.
Policymakers will set interest rates in Frankfurt this week for the first time since governments in Paris and Berlin both collapsed over budget talks for next year, with the ongoing turmoil largely obscuring their view of the two biggest economies in the currency region they manage.
While Europe’s political vacuum won’t derail a likely interest-rate cut on Thursday, it does cast doubt over the value of quarterly forecasts being currently compiled, and compounds the uncertainty confronting officials just as they await the incoming presidency of Donald Trump and his threatened trade tariffs.
Among the most pressing questions for the ECB are how fiscal policy will develop in both countries, and how the prospect of government drift and upheaval will affect consumers and businesses. The answers threaten to pull the central bank “in opposing directions,” according to Fabio Balboni, an economist at HSBC in London.
“On the one hand, political and, crucially, policy uncertainty might affect consumption and investment, affecting growth negatively,” he said. “On the other, the ECB has been looking for some fiscal tightening next year to help cool down inflation, and the bulk of it is meant to happen in the France — but the current situation calls into question whether such adjustment will actually take place.”
French President Emmanuel Macron has vowed to quickly appoint a new prime minister after Michel Barnier’s bid to cut the deficit by around €60 billion ($63.5 billion) fell through. His priority will be to win approval for a new budget from the same parliament that just rejected one.
In Germany, new elections are scheduled for February, following the breakdown of Olaf Scholz’s three-party coalition that had frequently been at odds over economic policies. Even if opposition Christian Democrat Leader Friedrich Merz comes first in that vote, protracted talks will likely follow over the make-up of a new governing alliance.
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“Downside risks to Germany’s outlook predominate — if they materialize, 2025 could be yet another lost year.”
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With the ECB currently shifting focus from bringing inflation under control to spurring lackluster growth, officials are anticipated to deliver a fourth quarter-point rate cut this week.
They will also sign off a new round of projections which are probably based on developments only until the middle of November, the typical cut-off date in the last forecasting round of the year.
The Governing Council already accelerated a rate cut in October when it looked like the euro area’s economy might be losing momentum. Back then, President Christine Lagarde listed a number of developments outside of the euro area when describing the biggest threats to activity, including wars in Ukraine and the Middle East.
Days later, Trump’s US election victory and his pledge to raise tariffs made a new trade war the top concern. But now, the main sources of uncertainty suddenly seem to originate at home.
“For the ECB, what’s important is that we have more uncertainty over the euro-zone outlook — one more element that is weighing on growth,” said Charlotte de Montpellier, an economist at ING.
That also matters for the longer term, as the difficult political situation may stymie any reform efforts to address challenges identified in former ECB chief Mario Draghi’s report on the region’s economic malaise, she said.
Another complication is the fallout on financial markets. A spike in French bond yields has caused speculation that the ECB will have to use its crisis tool to rein in borrowing costs. But Bundesbank President Joachim Nagel made clear that the so-called Transmission Protection Instrument isn’t there to cap movements resulting from political problems.
For now, the ECB’s best option to weather the turbulence might be to put more emphasis on plausible outcomes instead of relying on a likely base case, a strategy honed during the pandemic and ahead of Russia’s invasion of Ukraine, said Felix Huefner, an economist at UBS in Frankfurt.
“Central bankers will have have to think in scenarios,” he said. Because of the many moving parts, the ECB must to wait for more data — starting with December business surveys from S&P Global and France’s Insee — to gauge the impact that political turmoil is having on companies and households, he said.
In Germany, business expectations remained subdued last month after the government broke apart. According to Bloomberg Economics, political troubles there will act as a further drag on an economy that’s already in the doldrums.
The prolonged weakness has become a major point of debate in the election campaign. Solutions under discussion include a loosening of the country’s constitutional borrowing limit, though any impact won’t materialize quickly, according to Robin Winkler, chief economist for Germany at Deutsche Bank.
“Political uncertainty is likely to drag on until the spring, weighing on investment for at least the first half of the year,” he said. “It is really the outlook for 2026 and beyond that is highly dependent on the outcome of the elections and the coalition talks in the new year.”
How all of that will affect the ECB’s rate path is difficult to predict. Economists currently see quarter-point cuts at every meeting through June, while investors keep speculating about a bigger move at some point in the coming months. Balboni at HSBC agrees that this scenario remains an option in light of recent events.
“If demand continues to disappoint as the more recent drop in consumer confidence pushes consumers to spend less, and policy uncertainty leads firms to postpone their investment decisions, an acceleration of the pace of rate cuts next year could well be on the cards,” he said.
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