FRANKFURT: Officials arriving at the European Central Bank’s annual retreat in Portugal this week will struggle to escape the political drama engulfing the eurozone’s second-biggest state.

Billed as a chance to ponder hot economic topics from a more academic vantage point, this year’s conference in the hillside resort of Sintra starts a day after snap elections in France that are rocking the continent just as the ECB begins lowering interest rates.

The turmoil risks overshadowing potential positive news today in the form of a June inflation reading that’s nearer the 2% goal and may have lifted hopes that its first cut in borrowing costs will soon be followed by more.

Instead, concern is bubbling up over France’s financial trajectory and possible ECB action to calm investors.

Despite central bankers typically being hesitant to wade into national politics, “the ECB will be watching closely as it may have implications for financial markets and the transmission of monetary policy”, said Jens Eisenschmidt, an economist at Morgan Stanley in Frankfurt.

“The political developments in France and beyond will not have any impact on interest rates in the foreseeable future,” he said.

“In an emergency, it will be about buying bonds to stabilise the markets. But reality is complex and so things tend to be intertwined.”

Marine Le Pen’s anti-immigrant National Rally looks set to surpass the left’s New Popular Front and Emmanuel Macron’s party to take the largest number of seats in France’s parliament, though the full picture won’t be clear until next week’s second round.

A big question is what the result will mean for spending, with the European Commission reprimanding the country less than two weeks ago for running large budget deficits.

Irrespective of who wins, Bloomberg Economics foresees a clash with Brussels.

Bloomberg Economics said: “Since Macron called a snap election, markets have been jittery.

“That’s not surprising. The nation’s financial outlook was already challenging, enough to likely trigger the European Union’s Excessive Deficit Procedure.

“And relative to the outlook before the election was called, we think the tendency will be to borrow more, irrespective of who forms the next government.”

The ECB must assess the fallout in financial markets, where the spread between French and German government-bond yields has already widened significantly - evoking Europe’s debt crisis last decade and prompting debate on whether policymakers should step in.

Officials, including President Christine Lagarde, said they’re monitoring the situation but haven’t witnessed the kind of disorder to justify activating the ECB’s Transmission Protection Instrument (TPI) - created in 2022 to ward off undue market turbulence as rates were lifted.

“I don’t see that discussion on the TPI is topical for the moment,” Finish central bank chief Olli Rehn said.

There may, though, already be implications for the assumptions that help underpin ECB policy.

While it currently sees inflation sustainably hitting 2% towards the end of 2025 as the bloc heals after a mild recession, political uncertainty can derail or damage the economy through weak investment, according to S&P Global analyst Sylvain Broyer.

“It’s clear that the main driver will be consumer spending, which the political uncertainty is unlikely to affect,” he said.

“But the recovery in investment that everybody has in mind for 2025, it could definitely be weakened.”

Indeed, Bank of Italy governor Fabio Panetta warned last week that political uncertainty resulting from elections is a risk that must be considered alongside fragile geopolitics.

“It can trigger capital outflows and currency depreciations, creating upward price pressures,” he said.

“But it could also shake confidence and weaken demand, halting or even reversing the fragile recovery we have seen so far.”

A panel discussion in Sintra, chaired by executive board member Isabel Schnabel, is dedicated to geopolitical shocks and their impact on inflation.

Research papers presented during the week will deal with the drivers of the recent surge in prices, European productivity, interest rate cycles since the 1970s and the economics of biodiversity loss.

Today’s inflation report from Eurostat may provide welcome relief, with economists anticipating a slowdown to 2.5% from 2.6% in May.

In recent days, some officials have begun sketching out a path for one or two more rate cuts this year - broadly in line with markets current thinking.

Lagarde, who was scheduled to open the forum last night and appear alongside US Federal Reserve chairman Jerome Powell today, has warned of “bumps in the road” as price gains return to target.

Chief economist Philip Lane said officials must be “agile” in responding to surprises.

For Claudia Panseri, chief investment officer for France at UBS, Europe’s election jitters aren’t the key focus. The ECB will be watching the consumer price index more than the political issue,” she said.

“Clearly the ECB needs to cut rates. There is some recovery in the economy, but we still see that this recovery is pretty shy,” said Panseri.

 - Bloomberg