By Dhara Ranasinghe and Stefano Rebaudo
LONDON, Oct 23 (Reuters) - The European Central Bank meets on Thursday against a backdrop of upheaval in France and an Iran war that is keeping energy prices above $100, meaning inflation risks remain elevated.
"How do you set rates against that backdrop? It's incredibly difficult," David Coombs, head of multi-asset investments at Rathbones Asset Management, said.
Here's a look at five key questions for markets ahead of the October meeting.
1/ What will the ECB
do?
Leave its key interest rate unchanged at 2.5%.
A pause is widely anticipated after the ECB raised rates in June and September to counter rising inflation, as the Iran war pushed up energy prices.
Economists polled by Reuters expect a quarter-point rate hike in December.
"I don't think they've become materially less worried about inflation here," MUFG senior economist Henry Cook said.
2/ What will the ECB say about the rate outlook?
It's likely to stick with a data-dependent approach.
Caught between high inflation, at 3.8% in September, and concerns that rising government bond yields could hurt growth, policymakers have recently argued for what ECB President Christine Lagarde called a "measured response."
"There will be a definite flag to the tightening in financial conditions and how it should slow growth and hence curb inflationary pressures," said Barclays' head of euro rates strategy Rohan Khanna.
"But also, plenty of uncertainty around the conflict and the outlook for energy prices."
3/ How worried is the ECB about an energy-driven inflation rise?
Comments from officials such as ECB chief economist Philip Lane suggest the ECB is not overly worried, for now, about high energy costs leading to other prices and wages rising.
A muted increase in core inflation, which excludes food and fuel prices, to 2.5% last month from 2.4%, suggests that high energy costs have yet to generate the sort of second-round impacts that could set off a hard-to-break inflation spiral.
Still, with oil up almost 80% this year and headline inflation above its 2% target, the ECB will likely stress vigilance.
"If the war in Iran escalates, or if we see further pressure on energy prices, the risk is still more rate hikes in 2027," said Bas van Geffen, senior macro strategist at Rabobank, adding he did not have any penciled in for next year.
Markets price in at least two hikes by mid-2027.
4/ What about the French bond selloff?
Well, the ECB is watching.
French 10-year borrowing costs just hit 24-year highs above 5% and a weakened government is grappling with violent protests that could undermine efforts to improve fragile finances.
Also, the premium investors demand to hold 10-year French bonds over safer Germany is at 170 bps, up from 92 bps when the ECB met last month.
But don't expect the ECB to act soon with measures such as the Transmission Protection Instrument that allows it to buy bonds from any member state experiencing an "unwarranted, disorderly" tightening of its financing conditions.
France should solve its own debt problems through fiscal consolidation, says Lagarde.
The ECB could hold back on rate hikes if it thinks a crisis in France could hurt economic growth materially, Berenberg chief economist Holger Schmieding said.
"If there are serious contagion effects from a hypothetical French crisis to other countries where the fiscal policy is much more sustainable, the ECB would probably use its TPI to shield these other countries, not France," he said.
5/ Who will replace Lagarde?
The ECB chief, who could be appointed as the next World Economic Forum chair as early as November, will likely be pressed on succession.
The former central bank governors of the Netherlands and Spain, Klaas Knot and Pablo Hernandez de Cos, are seen as frontrunners.
Lagarde's exit would open a second vacancy on the ECB's six-member Executive Board after Isabel Schnabel's recent resignation. Chief economist Lane is meanwhile due to step down in May.
Lagarde's term is scheduled to end next October. Leaving early allows time for a new ECB chief to be picked before France's spring presidential election. A snap Spanish election could also impact the politics around ECB succession, analysts said.
(Reporting by Dhara Ranasinghe in London and Stefano Rebaudo in Milan; Editing by Toby Chopra)
