Commentary: Waiting for the German cavalry

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The Independent Online
The financial markets can usually sniff out weakness, and there are few fans of the Government's recent performance in the Square Mile.

It is hard to remember a period when any administration, let alone a Conservative one, has been so reviled for drift and indecision. With sterling still sliding in the wake of the Sunday Times's story about Downing Street rifts, the Prime Minister and his Chancellor badly need the cavalry to come to the rescue.

Despite their recent appearances for the enemy, the most likely reinforcements continue to be General Helmut Schlesinger and his Frankfurt regulars. Maybe on Thursday or maybe a fortnight later, the Bundesbank may finally deliver a second tranche of the modest interest rate cut extracted from it last September.

A fall in German rates will cut the differential with British rates as surely as a rise in British ones, much to the relief of Treasury officials who prefer the pound to swim rather than sink.

In Germany the first hurdle is the talks on public sector pay. If they come in at around 3 per cent, the Bundesbank might be impressed enough about the signal to other wage-bargainers to edge interest rates down by half a point. If the government were then to rein in its budget deficit the way might be clear for another half point off short-term rates. The pressure on the French franc within the exchange rate mechanism is an additional reason to act.

Any easing is not, though, going to be a lot to write home about. Despite the accumulating evidence that the German economy is now in a good old-fashioned recession on any definition of the term - yesterday's figures showed a 3.7 per cent fall in industrial output in just two months to December - the Bundesbank's official doctrine has always stressed that it is not its task to steer activity in the economy. What matters is price stability, and inflation is still far ahead of the council's 2 per cent target.

The emphasis on prices is one of the reasons why the Bundesbank is even picky about how the deficit is cut. It wants spending cuts, not tax increases. It does not like direct tax rises because they reduce incentives, and it hates indirect tax increases because they raise prices. (Perhaps 0.5 of a point of the recent acceleration in German consumer inflation to 4.4 per cent is due to VAT rises).

Nor has the council yet fallen out of love with its wayward monetary aggregates, even though the German pattern of high short-term interest rates (at 8.5 per cent) and low long-term ones (at 7.1 per cent) encourages savers to pile cash up in the interest-bearing accounts that comprise M3. When the German cavalry does emerge, it is less likely to be at a stately trot.