Traders said it was another coup for the Bundesbank, which prides itself on its capacity to ambush the markets, as the key German discount rate was cut from 4.5 per cent to 4 per cent.
France was among those Continental countries to hold rates, prompting the franc to rise to its highest level against the mark for almost six weeks.
Sterling rallied three pfennigs to close at DM2.25 and weakened a point against the dollar. The London stock market surged as fears of an early rise in interest rates brought about by currency weakness receded. The FT-SE 100 closed 33.9 points up at 3,176.2.
The unexpected reduction in German rates was swiftly followed elsewhere in Europe as the Swiss, Belgian and Dutch central banks cut base rates. The French stock market soared on hopes of similar reductions.
The Bundesbank comprehensively wrongfooted the markets, which had started the week in the confident belief that the bank's council would keep rates on hold at its meeting on Thursday. Instead the bank made a sharp cut in the discount rate, which sets the floor for the whole interest-rate structure in Germany. This was the first reduction for almost a year.
The Bundesbank also reduced the repo rate, used for most day-to-day interventions in the money markets, from 4.85 per cent to 4.5 per cent. The Lombard rate, which sets the ceiling for official interest rates and only matters when monetary conditions are tightening, was left unchanged at 6 per cent.
A statement from the Bundesbank made clear that the recent strength of the mark - up 10 per cent against the dollar this year - was a principal reason for the decision to cut rates. This was "dampening" the growth in the money supply, which was also "persistently weak" for domestic reasons
The bank was able to cut rates because M3 growth, distorted in 1993 and 1994, was well within the "ambitious" target corridor of 4 to 6 per cent between the fourth quarters of 1994 and 1995. In February it fell at an annualised rate of 3.8 per cent on the fourth-quarter average.
The decision to cut rates startled the markets because there were powerful arguments for keeping rates on hold. In a wide-ranging speech to financiers in Saarland last week, the Bundesbank's president, Hans Tietmeyer, described the annual rate of consumer price inflation of 2.4 per cent in February as "too high". On Monday the provisional figure for March disappointed by remaining at 2.4 per cent rather than falling to 2.3 per cent as had been hoped.
Another reason for keeping rates unchanged was the recent pay settlement in the key engineering sector of more than 4 per cent, considerably higher than expected. In the light of this, the Bundesbank had been thought unlikely to ease policy immediately ahead of the key public sector pay round, where unions are claiming 6 per cent.
The Bundesbank's decision is thought to have resolved a battle within the council between advocates of an easing of policy, led by Hans-Jurgen Krupp,and hawks, represented by the Bundesbank's chief economist, Otmar Issing.
Mr Krupp argued at the beginning of this month that a cut in rates was possible "because the economic upturn is not so strong".
The Bundesbank was at pains to emphasise that its decision to bring down rates did not constitute a sudden conversion to the cause of exchange- rate stabilisation. But it is clear that the sharp appreciation in the mark this year was pivotal in swaying the council to back a cut.
The strong mark is expected by the bank to keep growth lower and to suppress inflation by holding down import prices. It should also put pressure on industry to withstand wage claims.
The decision to cut rates was broadly welcomed within Germany. Ulrich Beckman, senior economist at Deutsche Bank, said the cut was fully justified because of the weakening of activity expected to arise from the appreciation of the yen. He expected a rollback in the mark's strength "but not a full one".
Most observers were prepared to accept the Bundesbank's insistence that the cut was made for domestic reasons rather than as a gesture to currency stabilisation. But there was more scepticism about the bank's contention that the decision was taken principally because of the outlook for money- supply growth.
Holger Fahrinkrug, senior economist at UBS in Frankfurt, pointed out that if that was the case the decision could have been taken earlier on the basis of this "questionable indicator". Comment, page 41Reuse content