The European Central Bank (ECB) faces a significant challenge as leadership crises in France and Germany, the eurozone’s two largest economies, create considerable uncertainty for monetary policy. This political vacuum complicates the ECB’s economic outlook and adds to the complexities of navigating an already challenging global landscape.
The recent collapses of governments in Paris and Berlin over budget negotiations have obscured the ECB’s view of these crucial economies. While a quarter-point interest rate cut is still expected this week, the ongoing political turmoil raises questions about the accuracy of the ECB’s quarterly forecasts and adds another layer of uncertainty to an already complex situation. The situation is further compounded by the looming presidency of Donald Trump and his potential trade tariffs.
A key concern for the ECB is the future direction of fiscal policy in France and Germany. How will the political instability impact consumer and business confidence? These questions present a dilemma for the central bank, according to Fabio Balboni, an economist at HSBC. Political uncertainty could negatively affect growth by dampening consumption and investment. Conversely, the anticipated fiscal tightening, particularly in France, intended to curb inflation, might not materialize due to the political upheaval.
French President Emmanuel Macron is tasked with appointing a new prime minister and securing parliamentary approval for a new budget after the previous attempt to reduce the deficit failed. Meanwhile, Germany faces new elections in February following the collapse of Olaf Scholz’s coalition government, potentially leading to protracted negotiations to form a new ruling alliance.
The ECB, currently focused on stimulating sluggish growth while managing inflation, is likely to proceed with its planned interest rate cut. However, the new economic projections, typically based on data up to mid-November, might not fully reflect the recent political developments.
Prior to the government collapses, the ECB had already accelerated a rate cut in October due to concerns about slowing economic momentum. At the time, President Christine Lagarde cited external factors, such as wars in Ukraine and the Middle East, as the primary threats to economic activity. Subsequently, Trump’s election victory and his trade tariff threats emerged as a major concern. Now, the primary sources of uncertainty lie within the eurozone itself.
The political instability introduces further uncertainty to the eurozone’s economic outlook, adding to the headwinds facing growth, according to Charlotte de Montpellier, an economist at ING. This situation could also hinder long-term reforms needed to address the region’s economic challenges.
Adding to the complexity is the impact on financial markets. The rise in French bond yields has sparked speculation about the ECB’s potential use of its crisis tool, the Transmission Protection Instrument (TPI). However, Bundesbank President Joachim Nagel clarified that the TPI is not intended to address politically driven market fluctuations.
Navigating this turbulent environment may require the ECB to adopt a scenario-based approach, focusing on plausible outcomes rather than relying on a single base case, suggests Felix Huefner, an economist at UBS. He emphasizes the need for more data, particularly December business surveys, to assess the impact of the political turmoil on businesses and households.
In Germany, business sentiment remained subdued even before the government’s collapse. The ongoing political uncertainty is expected to further weigh on the already struggling German economy, potentially delaying investment decisions.
The long-term consequences for the ECB’s rate path remain uncertain. Economists anticipate further quarter-point cuts in the coming months, but the possibility of a larger cut remains open, particularly if demand continues to weaken and policy uncertainty persists. The evolving political landscape in the eurozone’s core economies presents a significant challenge for the ECB, demanding careful monitoring and potentially requiring a shift in its policy approach.
