Economics: ERM or no, watch the Bundesbank

Click to follow
What an odd thing is this life outside the exchange rate mechanism. For some, our ejection from the ERM was set to provide us with new freedom. One City monetarist refers to the mugging of the pound on 16 September as 'Happy Wednesday'. The stock market, whose reaction to our ERM entry in October 1990 was to leap with joy, also leapt with joy when we left. Consistency, as Ralph Waldo Emerson said, is the hobgoblin of small minds.

The feeling that happy days are here again has not lasted long. The markets and businesses are still worried about what is likely to happen in Germany, and are none too impressed by the prospect of offshore political as well as geographic status. The pound is still sinking, losing 5 pfennigs against the mark at one point on Thursday merely because of the undignified slanging match between the Government and the German authorities.

Sterling is now 11.6 per cent below its average level of last year, boosting import prices and inflation, and probably ruling out another cut in interest rates. As the Governor of the Bank of England said on Tuesday, we 'cannot afford to ignore the exchange rate'. At one point last week, even the hope that German interest rates might come down again, making the mark less attractive to investors, was greeted with relief by the stock market, which gained 30 points on the FT-SE 100 index. Our new 'British monetary policy' is evidently not so different from our old German one.

I was also amused to hear about the Cabinet Thatcherites' description of policy. When asked what British economic policy would be outside the ERM, one minister said that it would be like Nigel Lawson's policy between 1983 and 1985. By choosing those dates, he excluded the early and disastrous experiment with monetarism but he also excluded the Lawson boom and the attempt to shadow the ERM.

What he had apparently forgotten was that the 1983-85 period ended with Mr Lawson's damascene conversion from floating to fixed exchange rates. The January 1985 sterling crisis was a searing experience, when bank base rates went to 14 per cent. Mr Lawson will no doubt reveal all about the pleasures of running policy without credible money supply targets or a fixed exchange rate in his forthcoming memoirs.

Meanwhile, the markets are right to keep their eyes on Germany. Although the Bundesbank failed to cut interest rates on Friday, there seems little doubt that German interest rates are now on the slow road downwards. The smallness of the 1/4 percentage point cut in the Lombard rate during the ERM crisis disguises a larger 0.7-0.8 point cut in money market rates, as the graph shows.

The reason for the easing was entirely international. Any more substantial cut in German rates will have to be justified by a turnaround in the domestic economy and inflationary pressures, and the Bundesbank's latest September report is as conservative as it could be: although it concedes that the pace of economic activity has slowed down, it also argues 'there can be no talk of recessionary trends'.

The Bundesbank is mesmerised by two factors, both of which mean that it is likely to ease policy at a glacial pace. The first is that inflation continues to be relatively high by German standards at 3.6 per cent. This compares with the 2 per cent that the central bank believes consistent with its duty to safeguard the currency.

The second factor is Germany's high money supply growth. With the favoured money measure M3 expanding by nearly 9 per cent over the year to August, well above the official 5.5 per cent ceiling, conservative council members like Lothar Muller are understandably worried.

The Bundesbank is being short- sighted. It is likely that M3 is behaving in the same misleading way as British M3 in the early Eighties. High interest rates themselves cause high loan demand (as companies roll up interest payments). In addition, high rates boost interest-bearing accounts at the expense of other assets. There has also been a sharp increase in the demand for marks as a convenient store of value for Eastern Europeans, a rise in money supply that has no implications for domestic spending.

Germany's inflation trends are probably a good deal better than it supposes. Although pay claims have accelerated this year to 5 1/2 per cent, the pressures appear to be easing not least because of the rise in unemployment. The inflation picture has in any case been exaggerated by the spending taxes that the Government imposed to fund some of the burgeoning costs of transfer payments to eastern Germany, which Deutsche Bank estimates will cost DM170bn (pounds 68bn) this year. Although last year's petrol tax dropped out of the year-on-year comparison in July, there will be a new complication in January. The rise in VAT from 14 to 15 per cent will add 0.7 points to prices.

The Bundesbank may also be ignoring its own research earlier this year, which showed that today's monetary policy affects the economy with a time lag of 10 quarters. Indeed, in Britain's case, the monetary lags may be even longer and more variable. The most appropriate image is that of Professor Frank Paish, who likened the use of interest rates to pulling a brick across a table top with elastic. Nothing happens, and then the brick hits you in the eye.

The German economy has not yet been knocked out, but it is stagnating. In the east, factory output may be stabilising slowly. But in the west, industrial production has now been falling for five consecutive months. It is now 4 per cent below the February level. With exports also down sharply in July and August, new orders dropping, stocks of unsold goods building up, and weak retail sales, the declines will continue.

Against this background, last week's report from Ifo, the Munich-based economic research institute, helped to distill the darker mood. After it warned that production plans were increasingly being shaded downwards, the Frankfurt bourse tumbled by more than 2 1/2 per cent. The DAX index of shares is now down 18 per cent from its May high.

The prospect of a German recession should begin to sap some of the recent strength of the mark compared with the dollar, yen and perhaps even sterling. In principle, these foreign exchange turnarounds can be startling. The rally from 1979 to 1985 took the dollar from DM1.70 to DM3.40 before plunging back down to less than DM1.60 by 1987.

On this occasion, the fall in the mark may be pronounced only if there is an escalation of social unrest in Germany. With the US recovery enfeebled by high debt, there is little prospect of a rapid rise in US interest rates. The yen is certainly weak on any calculation of competitiveness, but the fundamentals could easily be swamped by worries about the pricking of its property and equity market bubbles.

But a turn in the mark and the dollar would be the single most helpful development for UK interest rate prospects. It was the collapse of the dollar that helped to undermine sterling's position in the ERM. Its revival could allow the Chancellor to go below 9 per cent base rates without endangering sterling. In or out of the ERM, keep watching the Bundesbank.

(Graphs omitted)