The possibility that the next move in British interest rates might be up rather than down would have seemed remote even a couple of weeks ago. But now even the optimists have to acknowledge that there is some possibility of a rate rise in the next few weeks. If that were to occur, the trigger would be Germany.
The Bundesbank is more of a coalition than it seems to the outside. It has a reputation for surprising the markets, but this is as much a result of its structure as of any corporate desire to make a nuisance of itself. It has a strong and self- confident staff which will give the lead on monetary decisions; it has had a series of competent and self-confident presidents; but it also has a council which includes representatives from the regional central banks. They can and on occasion do swing a decision against the advice of the staff, as they did over the last rise in German interest rates. It is not only outsiders who are sometimes caught off balance by Bundesbank decisions; insiders are too.
The prelude to this Thursday's meeting was a couple of stories in the Frankfurter Allgemeine last week to the effect that the Bundesbank would increase its discount rate. The Bundesbank denied the first, whereupon the paper repeated the story, saying it was well-sourced. It does not take a great deal of experience in the way monetary authorities manipulate markets to work out what happened: senior people within the Bundesbank wanted the possibility of such a rise to be known ahead of the council meeting, but of course since the council had not yet met, the story had to be denied.
Why did people in the Bundesbank want the story in the market? Here one moves from near-certainty to surmise, but one plausible explanation would be that if the markets were prepared for a discount rate rise, the council would be less likely to vote in addition for a Lombard rate rise.
A word of explanation. The Bundesbank's monetary operations take place between two official interest rates, the discount rate and the Lombard rate. The discount rate is the floor; the Lombard rate the ceiling. The discount rate tends to attract the headlines, but in practice at a time of over-rapid monetary growth the Lombard rate is much more important. If you are operating just under the ceiling, it really does not matter how far below the floor is.
But the Bundesbank will have to sound tough. German broad monetary growth is running at 9 per cent a year, far above its target range of 3.5 to 5.5 per cent. Not only does the Bundesbank have to decide on the range for the second half of the year; it also has to face up to validating the previous overrun. So to have any credibility with its monetarist critics, it will have to make some noise. The regional chiefs will, on past form, want this too.
Bundesbank staff, however, unlike most of the Bundesbank critics, go to international bankers' meetings. They are aware of the damage that a rise in German rates would do to other EC countries. The German government certainly feels this way. It may not be particularly concerned about the impact of its interest rate policy on the US or Japan, but it did indicate at the recent Group of Seven summit that it is worried about the impact on Europe. The government does not set interest rates, but treasury officials talk to the same people as central bankers.
We tend to see German interest rates as a particular problem for Britian; witness the way some of our commentators and politicians go on about the intolerable situation of having our interest rates dictated by an unelected German institution. But this is a problem for the rest of Europe, too. Both France and Italy have had reluctantly to increase interest rates in recent months, in response to currency weakness. We have not had to do that, yet.
There are also some practical domestic reasons why the Bundesbank will not wish to push up interest rates. It is not fully clear why German money supply has been rising so fast, but some of the reasons have nothing to do with inflationary pressures in Germany itself.
One is the increased demand for marks in Eastern Europe. Marks are replacing dollars as the second currency of countries like Poland and Czechoslovakia. Another is the growth of subsidised lending to the former East Germany. A third is the fact that if short- term interest rates are higher than long- term ones, as they are at the moment, people tend to trade in long-term paper and put their money in deposits. A further rise in rates would make the money supply problem worse, not better.
The Bundesbank staff, then, will probably be trying to construct a monetary package which has a bigger bark than its bite. This could indeed include a rise in the discount rate, and might well have some other technical ways of squeezing bank lending. But there would be no rise in the Lombard rate and little general rise in mark rates on the money markets.
The rise of the mark in recent days has itself had the effect of tightening policy, so an argument can be made that it is not necessary to increase rates.
If this proves right, and there is no move in the Lombard rate, Britain may get away without increasing base rates. There are three lines of defence. One is to use up more of the 6 per cent band we are allowed under the ERM rules. The closer we move to the bottom, the greater the scope for currency appreciation as sterling becomes more attractive.
Any upward movement can be reinforced by the second line of defence, intervention. The third line of defence is to allow money market rates to rise a little, increasing the attractiveness of sterling, but not to allow it to rise by enough to trigger a round of base rate increases.
Finally it is worth making the point that the greater the sound and fury from the Bundesbank, the greater the possibility that the markets will see this as the top both for German rates and for the mark. Once the mark has peaked, money could return to sterling. All this, plus the strong words by the Chancellor and the Prime Minister, should be enough to render a rise in base rates unnecessary. But it is a 'should'; it is by no means certain.Reuse content