Taking advantage of the favourable inflation outlook, the Bundesbank cut its discount rate to 4.5 per cent and its Lombard emergency lending rate to 6 per cent. The move prompted more cautious cuts in leading interest rates by Italy, France, Belgium, the Netherlands and Denmark to stimulate their own emerging recoveries.
The news initially boosted the dollar on foreign exchange markets, with dealers expecting a co- ordinated increase in US rates from the Federal Reserve.
Against the mark, the dollar rallied by around one pfennig to DM1.68 and was up by half a yen to Y104.48, but encountered selling at these levels. After the Fed failed to raise rates, the dollar later fell back and by the London close it was little changed on Tuesday's finish at DM1.6721, though it held on to its gains against the yen.
Most now expect the US central bank to raise its own key rates in a similar half-point move next week. But even so, a number of analysts doubt that the dollar will rally significantly. George Magnus, of Warburg Securities, said: 'Even taking into account the widening interest- rate gap we still think the Americans are offering returns for financing their current account deficit that are woefully inadequate.'
Economists said the German reduction marked a strong bid by the Bundesbank to curb the stubbornly high level of M3 money supply growth. M3 had risen at an annual rate of over 15 per cent in March, well above the Bundesbank's target this year of a maximum 6 per cent.
By forcing short-term rates down, the Bundesbank hopes to encourage investors to switch funds out of M3 bank deposits and into longer-term investments like government bonds. 'The strategy is unusual, in that it turns the more conventional interest rate management of monetary growth on its head, but it points to the Bundesbank's determination to promote monetary capital formation,' said Hermann Remsperger, chief economist at BHF bank.
The dollar's weakness encouraged the Bundesbank to move quickly and more sharply than expected.
Recent Bundesbank intervention to support the US currency had been half-hearted, because of the German central bank's fears that this would further bloat M3 money supply. 'The Bundesbank would prefer to offer support by lowering German rates, and given such favourable conditions at the moment, it felt able to do so,' said Gerhard Grebe of Bank Julius Bar.
The drop in rates reflects the Bundesbank's belief that monetary developments in Germany are de- coupled from the US, Mr Remsperger said. Towards the end of the year, with US rates rising and German ones continuing down, there could be a convergence of short-term rates at around 4 per cent, he predicted.
With the inflation outlook likely to continue improving, economists are generally agreed that further rate cuts are to be expected. Running at 3.1 per cent in April, inflation is forecast to be around 2 per cent by the end of 1994. 'With things looking that good, the Bundesbank has realised it must convince investors once and for all that short-term rates are heading downwards and it is time to move into long-term assets,' said Ulrich Beckmann of Deutsche Bank Research. London analysts say that a 4 per cent discount rate later this year now looks realistic.
Eberhard Scholz, economist at Bayerische Vereinsbank, said the Bundesbank 'is shooting for a gap between short and long-term rates of around 2 per cent'. At present, the gap is just over 1 per cent. He called yesterday's central bank cut brave, because some observers may see it as disregarding high M3 growth.
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