Bundesbank not as black as painted

All eyes remain on the Bundesbank, but perhaps they should really be on the German economy.

The markets are spooked by the Bundesbank because they fear that the interest-rate cycle may be turning 18 months or two years earlier than they had expected.

The bond market's collapse on Wednesday was a delayed reaction to the warning of Hans Tietmeyer, the Bundesbank president, on Monday evening that German interest rates might be left unchanged. The effect was compounded by a smaller-than- expected cut in the Bundesbank's repo rate, which in turn led to the cancellation of the planned auction of four-year notes because of lack of demand. People took this to mean that the next move in rates might be up rather than down.

The trouble with this sort of discussion is that it is founded on the presumption that the Bundesbank is all-powerful. In fact, it will respond, usually in an ordered and sensible way, to the forces that shape the German economy. If one wants to know what the Bundesbank will do in six months - will it still be cutting short-term interest rates? - the thing to watch is the German economy.

As a cross-check, look at its policy now. If it is proving more cautious on interest rates than the market expected, this can be attributed to the sharper-than-expected recovery in the economy during the first quarter.

A few weeks ago the received wisdom was that, though the economy had bottomed out, the recovery would falter and there was even a danger of a second dip, leading to a double bottom. That view, accepted at the time in this column, now looks wrong. Growth in the first quarter was stronger than expected and the recovery, for the moment, appears secure. GDP figures for the first quarter are not available until 7 June, but it looks as though it will be up at least 0.2 per cent on the previous quarter, and up more than 1 per cent on the first quarter of 1993.

This gives a practical justification to the Bundesbank's unwillingness to push rates down further. If the Bundesbank is not cutting rates as expected, it is not because it is being pig-headed; it is because there is no immediate need for it to do so. The strengths of two sectors, housing and exports, have proved the pessimists wrong. Construction orders for non-residential property have been running down year-on-year since early 1992. But housing has soared: up 20 per cent or more through most of last year. Exports, too, have been strong, with the result that the trade surplus is at a three-year high.

Looking ahead, it is reasonable to expect demand for housing to slacken, for it has been largely driven by demand from new immigrants and immigration laws have recently been tightened.

However, the prospect for exports is quite bright. These depend on demand from the rest of the EU: about 70 per cent of Germany's exports go there, and the Continental recovery seems to be in place.

Market forecasts for economic growth in Germany this calendar year range from 0.75 per cent to close to 2 per cent. If growth is at the bottom end of that range, there will surely be at least one more cut in the discount rate, and a sustained gradual fall in the repo rates right through into next year. If the economy is going to grow at anything close to 2 per cent, rates could be expected to hold level through this year and to begin to rise early next.

So how will we know which view is more likely to be right: weak recovery needing a further monetary stimulus, or solid recovery suggesting that the next significant move in rates will be up?

There are a number of tests the economy must pass. One will be the impact of a tighter fiscal policy. Tax rises and spending cuts could, in theory, knock as much as 2 per cent off GDP in the next fiscal year. Will German consumers continue to pare back saving (as they have through the trough of this recession) to sustain consumption?

A second test will be that posed by the bond markets this week: if long-term rates in Germany have turned so early in the cycle, will monetary policy be tightened by the markets, rather than by the Bundesbank?

A third test concerns the mark. There is real concern in the markets about a super-strong mark, even though on purchasing power parity it is already at least 10 per cent over-valued against the dollar. A strengthening mark applies another form of monetary tightening.

To achieve growth of 1.75-2 per cent this year, the economy needs to fight not just against a tighter fiscal policy, but also a tighter monetary policy from high long- term rates and a stronger mark. This sounds a tough task. Accordingly, it would be wise to expect a pause in the German recovery within the next few months.

If and when that happens, there would still be scope for some further cuts in interest rates by the Bundesbank.