The emergency Lombard interest rate, the ceiling for money market rates, was cut by 0.25 percentage points to 9.5 per cent. The discount rate, the floor for market rates, was cut by half a point to 8.25 per cent. The 'repo' rate, at which the Bundesbank lends to other banks against the security of bills, was also reduced by half a point.
The FT-SE 100 was nearly 100 points higher than Friday's close as the Bundesbank council met during the morning to decide the size of the rate cut. But disappointment at the outcome saw the gain in share prices halved.
The FT-SE ended the day 51.2 points higher at 2,422.1, the largest one-day rise since the announcement of the Government's pounds 7.25bn foreign currency borrowing package to boost the pound.
In New York, markets surged as pressure on the dollar was released.
US stock prices were driven up from the start of trading, triggering restrictions on computerised program trading shortly after noon, when the Dow Jones industrial average passed the 50-point mark. But by the close of business the Dow was trading up 70.52 at 3,376.22.
Traders said the buying came from long-term investors encouraged by the German rate reversal.
The Paris bourse showed a 3.97 per cent rise, taking share prices to their highest level for almost two months. Share prices in Frankfurt rose by 4.4 per cent, the biggest one-day increase for 18 months.
Although German share prices rose strongly, economists in Frankfurt were divided on the wisdom of the Bundesbank's move. Ulrich Hombrecher, chief economist at Dusseldorf's Westdeutsche Landesbank, said he was surprised. 'The cut in interest rates was the price the Bundesbank had to pay to achieve a devaluation of the Italian lira,' he said.
Mr Hombrecher is an opponent of European monetary union and a strong critic of the central bank's decision to raise the discount rate by 0.75 percentage points to 8.75 per cent in July. But he was equally critical yesterday of the way the rate cut was handled. 'A rate cut under these circumstances is no good omen for a European central bank,' he said.
However, there was strong support for the Bundesbank's actions from the pro-central European bank lobby. Hans-Jurgen Wagner, economics spokesman at Commerzbank in Frankfurt, denied that the Bundesbank had come under any political pressure from Bonn. 'It is not likely,' he said. 'The decision signals strength and the ability of the Bundesbank to react adequately.'
Ulrich Beckmann, senior economist at Frankfurt's Deutsche Bank Research, was equally forthright. 'There are no doubts about the credibility of the Bundesbank', he said.
Mr Beckmann expects a further interest rate cut by the end of the year, claiming that yesterday's move was just the start of a U- turn. 'The domestic situation is quite different now,' he said. 'The economic development is slower than the Bundesbank had expected in July.'
The Bundesbank president, Helmut Schlesinger, justified yesterday's move - less than two months after the central bank had raised its discount rate in a tough anti-inflationary signal - in terms of the unsustainable pressures within the European exchange rate mechanism exerted by the fall of the Italian lira. 'We had to get ourselves out of this currency trap,' Mr Schlesinger said.
The Bundesbank said the interest rate cut had been the price it had to pay to regain control of its monetary policy.
Bundesbank sources said a realignment was necessary to remove the need for support buying of lira.
Hamish McRae, page 25