Lagarde set to hike again before her departure

Direction of travel is clear

The ECB kept its key policy rates on hold as was widely expected. In the press conference that followed, ECB President Christine Lagarde explained that the Governing Council had discussed a rate hike at the meeting, but in the end decided unanimously to leave interest rates on hold. In the end, it decided that it was in a sufficiently good position to wait for more data and that the upcoming period would be information-rich. Still, she left very little doubt that the ECB was on course to hike its policy rates at the next meeting in December. She noted that the direction of travel was clear to ‘all of us’ in the absence of surprise developments. We continue to expect the ECB to raise its key policy rates by 25bp in December, with an additional move coming in March to take the deposit rate to 3%.

Inflation risks to the upside

Since the last Governing Council meeting, there had been two opposite developments in terms of the inflation outlook. On the one hand, energy prices had risen further; on the other, government bond yields had moved higher, led by French securities. The ECB addressed both of those. She noted that ‘the increased magnitude and duration of the energy shock, as well as the implications for indirect and second round effects, are likely to drive up inflation and lower growth’. Somewhat contradicting the press statement, she mentioned that the risk of second-round effects had not increased further. Meanwhile, the statement also noted that ‘financing conditions have tightened since our last meeting, which is likely to weigh on inflation and growth’. However, on balance the ECB continued to judge that the risks to the inflation outlook are to the upside.

Lagarde stresses that the ECB has instruments

Indeed, we think that financial conditions would probably need to tighten much further for the ECB to take further rate hikes off the table given that energy prices are posing increasing risks to inflation. In addition, changes in the trajectory for policy rates might not be the answer. The ECB President seemed to go out of her way to suggest that the central bank had tools to act in the event that the situation in sovereign bond markets threatened monetary policy transmission. She noted that should market developments threaten the smooth transmission of monetary policy ‘including through unwarranted and disorderly market movements’, the Governing Council had the ‘instruments available to respond, and the criteria and conditions under which this applies are well known, they are published.’ Ms Lagarde is most likely referring to the TPI. We think we are probably quite far away from a situation in which the ECB would intervene in bond markets (see our note here). However, the ECB might be firing a warning shot.

Lagarde hints at return to politics

The announcement that President Lagarde will step down in February naturally raised questions about the reasons for her early departure. Lagarde’s stated reasons were to have the “freedom of speech” and “freedom to engage” on non-monetary policy matters, adding that “my voice can help in relation to principles dear to my heart.” Lagarde has repeatedly ruled out standing in the French presidential election, including today in comments to Euronews (“I’m not a candidate for anything”). Nevertheless, her comments at the ECB press conference could be read as leaving open some form of return to public or political life.

Could she theoretically stand in the French presidential election?

The timetable would certainly be very tight, with just 70 days between her scheduled departure on 7 February and the first round on 18 April. To stand, she would need to secure 500 elected official endorsements by 12 March, while also establishing herself quickly enough in French politics to be a credible candidate. The official campaign would begin on 5 April.

She could, in principle, prepare discreetly before leaving the ECB, although this could be difficult to keep under wraps and might complicate her final weeks as ECB president, including her final GC meeting on 2 February. Politically, however, the possibility is not entirely far-fetched. Lagarde could potentially emerge as a consensus candidate for the currently fragmented Macron-aligned centre, particularly if neither Édouard Philippe nor Gabriel Attal establishes a clear lead. Her standing with the French public is also noteworthy: 46% had a favourable opinion of her in the IFOP-Fiducial survey conducted on 2-3 September, putting her level with Philippe.

Knot’s chances of becoming ECB president have probably risen

Lagarde's early departure also brings the succession question firmly back into focus. Earlier this year, we argued that Klaas Knot could emerge as a compromise candidate. Although traditionally seen as a hawk, Knot became more pragmatic and centrist over the course of his time on the Governing Council, while retaining a hawkish twist. That could make him acceptable to a relatively broad group of finance ministers. Pablo Hernández de Cos has been cited as the main alternative frontrunner, and also has a good chance given that Spain has yet to hold the ECB presidency. However, he may be viewed as being on the dovish side of the spectrum. Recent bond market woes in France could also strengthen the case for Knot, given his likely more hawkish reaction function on bond market intervention. His recent comments suggest he supports the ECB's lender of last resort function (see here), but market moves would need to become unjustified and/or eligibility restrictions dropped following credible French fiscal commitments. Still, the process is highly political and there remains plenty of room for a surprise candidate. Indeed, Lagarde herself was not initially among the favourites when she was appointed.