By Francesco Canepa and Balazs Koranyi
FRANKFURT, Oct 29 (Reuters) - The European Central Bank is set to keep interest rates on hold on Thursday in a well-telegraphed decision that is likely to be overshadowed by questions about bond-market turmoil in France and ECB President Christine Lagarde's own future.
The euro zone's central bank has already raised rates twice since June and is expected to resume tightening in the coming months as policymakers seek to prevent an oil-price shock linked to the Iran conflict from feeding into other prices and wages.
But it must also contend with a surge in government bond yields — especially in debt-laden France — that has pushed up borrowing costs for households and businesses and which Lagarde has said will curb growth and inflation.
Caught between persistent inflation risks and deteriorating financing conditions, the ECB is widely expected to keep its deposit rate at 2.5% this week while signalling that another increase, potentially as soon as December, remains likely.
"The ECB will likely indicate that the recent further spike in oil prices has tilted the risks to inflation even more to the upside than seemed to be the case in September," Holger Schmieding, chief economist at German bank Berenberg, said.
Money markets are currently pricing roughly three further rate increases, which would take the deposit rate to 3.25%.
LAGARDE TO FACE QUESTIONS ABOUT HER FUTURE
Lagarde is set to be quizzed about her own tenure at Thursday's press conference amid speculation she may leave before presidential elections in her native France in the spring, despite having a year left of her ECB term.
An early departure would allow French President Emmanuel Macron and other European Union leaders to fill one of the bloc's most powerful economic positions before a vote that opinion polls suggest could be won by the far right.
Reuters reported this month that the World Economic Forum could appoint Lagarde as its next chair as soon as November, hastening her exit and a wider reshuffle at the top of the ECB.
"It's far from an ideal situation to have any uncertainty around leadership while the central bank grapples with tighter financial conditions, higher energy prices and more uncertainty around the broader macro outlook," Henry Cook, a senior economist at Japanese broker MUFG, said.
The former central bank governors of the Netherlands and Spain, Klaas Knot and Pablo Hernandez de Cos, are seen as frontrunners for the ECB presidency.
FRENCH TURMOIL IN FOCUS BUT NO ACTION
The more immediate challenge for policymakers may be turmoil in bond markets.
A global rise in yields, fuelled by stronger growth expectations, higher debt issuance and massive investment linked to artificial intelligence, is pushing up borrowing costs for governments, households and businesses alike.
In France, investors have become increasingly uneasy about the country's growing debt burden and uncertain fiscal outlook following this year's elections. Concerns have been amplified by suggestions from parts of the political left that debt held by the ECB could be written off.
The result has been a sharp increase in French borrowing costs. France is now paying some of the highest yields in a quarter-century to raise money on bond markets, while the premium investors demand to hold French debt over benchmark German bonds is larger than for any other euro zone country.
That has fuelled speculation that the ECB might be forced to respond, if only verbally for now.
"It remains essential in our view that the possibility of an intervention by the ECB is preserved," said Gilles Moec, chief economist at French insurer AXA Group.
Any actual intervention still appears remote.
The ECB's first line of defence would probably be flexible reinvestment of proceeds from bonds acquired during its vast asset-purchase programmes of the previous decade.
Beyond that, it could activate its never-used Transmission Protection Instrument (TPI), a scheme designed to counter what policymakers deem unjustified market pressure.
"For now, French risk seems to remain contained in France but if it were to spill... the ECB may consider deploying TPI on other euro members while holding the line on France," economists at fund-management firm Algebris wrote in a note.
(Editing by Catherine Evans)