Comment: Budget rate cut still not inevitable

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The Independent Online
The Danes have presumably been given a respite and the Irish will presumably be sick as parrots, but that is the way the Bundesbank operates.

The craft of central banking requires a certain duplicity - the ability to face in one direction and move in the other. Were a central bank to be completely predictable it would be easy for the market to make money by correctly predicting its moves. It is just that the Bundesbank is particularly good at delivering surprises.

Looked at rationally, the cut in the Lombard and discount rates is important, surprising and sensible. It is important because it is a real cut rather than the token cut made last September just ahead of sterling's eviction from the ERM. The easing of reserve requirements, incidentally, is probably of even greater practical significance than the interest rate cuts, for this measure will increase the profitability of German banks and so affect their willingness to lend.

It is a surprise partly because it runs counter to everything that its president was saying only last Thursday, but also because - though it has come in the nick of time to save the Danish krone from devaluation - had it come a week earlier it might also have saved the Irish punt.

The only conclusion one can draw is that the Bundesbank considers the krone to be a core currency worth protecting and the punt is not. This is precisely the same message the Bundesbank gave last September when it gave positive help to the French franc over and above its obligations under ERM rules, but only followed the rules to help sterling.

Heading down

It is sensible because the German economy is heading down very fast indeed. There are technical objections to cutting rates in such a decisive way when money supply is still growing fast and practical objections because Germany's inflation rate is still about 4.5 per cent.

Moreover, the cut comes in the middle of its wage round. But all these objections should be seen against a background of a German economy that will probably contract by about 1 per cent this year, maybe - though this is not yet in many forecasts - by more.

What happens next? Because the move was unexpected it will take a few days before the full implications are absorbed by the markets. There was some of the usual 'too little, too late' comment yesterday, and the timing was odd. But since the directional signal is so clear it seems more sensible to focus on the fact that the trend of European interest rates is now clearly down rather than fuss about the size or timing of the cut.

That said, no one should assume that the ERM is still safe either with its present parities or under its present rules. The tensions will recede for a few weeks, but it would be surprising were pressures on the krone not to resurface.

The decision of the Irish government on the punt may seem more comfortable were, in three months' time, the krone to be devalued.

As for the French franc, the balance of probability is now that it will maintain its present parity until the elections. But after that the political balance will have shifted in favour of devaluation, which will follow before the summer is out.

By then the nature of the ERM will have inevitably changed. It is now accepted wisdom that there should be frequent and small changes in parities, with the central bankers encouraging changes ahead of the foreign exchange market rather than having parity changes dictated by the exchanges. The Bundesbank now wants this. So does the EC commission. It would seem a fair bet that, given this particular combination of supporters, the ERM will change.

What has not been thought through is how that change will (or could) be managed. It may be unmanagable, in that the political significance attached to exchange rates is too great to allow the small but frequent adjustments that Frankfurt and Brussels seek.

And Britain? The Bundesbank rate cut undoubtedly comes at a helpful time. Sterling was already coming up yesterday morning ahead of the Bundesbank announcement, thanks to a big overseas strategic buyer. On a long view that must be sensible, for the pound is now significantly below its purchasing power parity against the mark (about DM2.65) and a touch below against the dollar (about dollars 1.50). Being below PPP does not, of course, mean that recovery begins at once, but the universal gloom about sterling ought of itself to be a buy signal.

The central policy issue is whether the authorities are taking too many risks with inflation. The Bank, encouraged by the very slow rise in unit labour costs in manufacturing, apparently thinks not.

Input costs

On a two-year view that is probably right provided sterling comes up a little from its present levels. But input costs have risen sharply from the fall in sterling. In the next few months the underlying inflation rate, now only just below the top of the 1-4 per cent range, will probably push a little above 4 per cent.

The sensible conclusion would be that it is just as likely that the next move in UK interest rates will be up as it is that it will be down. The market's presumption is that there are further cuts on the way, with the main debate being whether bottom is 4 per cent or 5 per cent.

That presumption fails to take into account the scale of the expansionary impetus given to the economy by measures since Black Wednesday. That impetus hit an economy that was already on the point of recovery. Final figures are not yet available, but it looks very much as though demand last year actually rose a little.

Add the fiscal and monetary expansion, and it is inevitable that the economic growth will resume. Indeed, it is already happening - witness the car sales figures.

So, while the surprise cut by the Bundesbank ought to take the heat off sterling, it does not make a Budget cut in base rates inevitable. The slide of sterling over the past few days should have given the authorities a fright.

It may also have given consumers and businesses a fright, thereby undermining the reason for the cut in the first place - to boost confidence. It is not clear that the British authorities appreciate quite the level of distrust they generate. The Bundesbank may be wrong-headed, but it still carries enormous respect.