No need to worry about Bundesbank

The Bundesbank's refusal to cut German rates last week agitated foreign exchange and interest rate futures markets. Yet in all this speculation on the timing of the next cut, the markets, and many commentators too, are taking their eyes off the ball. Now that European exchange rate mechanism currencies are floating within wide bands, the timing of interest rate reductions is much less important than the issue of where European interest rates are ultimately going as the current cycle plays out.

The markets' answer to that is highly conservative, not to say downright unimaginative. Interest rate futures imply that German rates will be just under 6 per cent in the new year, down to about 5.5 per cent by the middle of 1994.

Here in the UK, short-term rates are expected to be around 5.5 per cent at the end of the year but not to change much thereafter. Some commentators forecast more aggressive reductions but people are not putting their money where their mouths are.

Ignore monthly indicators of industrial production, orders and business sentiment, which fluctuate randomly. Forget statements about the imminent upswing, from government ministers or central bankers; their interest is evident. Focus instead on the forces known to be acting on the key German economy.

Consider first German export prospects. Virtually every German recession since the Second World War has ended with a pick-up in exports. That is, no doubt, why the Germans themselves expect this one to do the same. Gunter Rexrodt, the Economics Minister, recently said as much.

Three elements, however, reduce that prospect to a fantasy. First the real value of the German mark (adjusting for relative prices and unit labour costs in Germany and abroad) has risen by 40 per cent over the past decade, since Germany last exported its way out of recession. Germany's prices are uncompetitive. Its export growth was generally slower than that of France, for example, during the 1980s, until the boom in 'exports' to eastern Germany after unification. Moreover German competitiveness always improved during past recessions, as a prelude to recovery. This time it continues to deteriorate as other ERM countries devalue against the mark.

Second, not only is Germany condemned to lose market share but its markets are sluggish. Almost the whole of Europe is in recession from trying to emulate German monetary policy. No doubt monetary policies will now change. Even an immediate policy change would not restart growth before mid-1994. Moreover easier money elsewhere in Europe could raise demand but could well push the mark even higher. The US and UK are growing only slowly and cannot act as locomotives for Europe. Japan remains in recession.

Third, however the world recovers, it is unlikely to be through an investment boom. Spare capacity remains considerable from the worldwide investment boom of the late 1980s. Yet German industry is specialised in capital goods production.

It follows that if exports will not come to the rescue, Germany must recover through an unusual pick-up in domestic demand. Two factors militate strongly against that. First is wages policy and the state of the labour market. Unemployment is rising fast and every day brings announcements of further lay-offs. That will reinforce employers and the authorities in pushing for continued low pay settlements. Average wages, growing at 3.5 per cent, are falling behind inflation, running at over 4 per cent. Inflation is coming down, but so may average wages, and employment is certainly falling. Total wages will continue to lag behind inflation.

That fits in with the export orientation of German policy-makers. They think that low wages cut costs relative to those of foreigners and set up the export-led recovery. True in principle, but such is the relative uncompetitiveness at present that a few percentage points off wages will make no difference to exports. Yet it will hit consumer demand - a factor the policy-makers do not appear even to consider.

The second factor is fiscal policy. In the post-reunification boom fiscal policy moved strongly to expansion as funds were borrowed and transferred to the east. The German government, under foreign criticism and pressure from the Bundesbank, has become alarmed at the scale of public borrowing. It is therefore attempting to shrink the deficit despite recession. In other words having been pro-cyclical in the boom, fiscal policy is moving strongly pro-cyclically now to deepen the slump.

The government has already brought in higher VAT and taxes on interest income; it has announced increases in fuel taxes and social security charges for next year. Cuts in social and other spending of DM25bn (pounds 10bn) a year (nearly 1 per cent of GDP) are planned, with the first package for 1994 already announced. Further tax increases are scheduled for 1995, including a swingeing 7.5 per cent income tax surcharge.

The tax and spending measures for next year alone, amounting to 1.5-2 per cent of GDP, are quite enough to eliminate any growth in domestic demand on their own. If German households really believe what is threatened for 1995 they are likely to go home and close the door.

With no momentum in the economy at present and the global situation, wages and fiscal policy all making for recession, what force exists to stimulate the economy? The answer is only monetary policy. Of course, the Bundesbank does not set monetary policy to smooth the cycle in real activity but to control inflation.

With continued stagnation, if not recession, in prospect, inflation in Germany must be expected to fall. While prices in August were over 4 per cent above their level in August 1992, they were only 3.5 per cent above their level of six months before, at an annual rate, and just 2.5 per cent above their level of three months earlier (annual rate). Seasonal factors flatter that comparison somewhat but it is reasonable to suppose the trend is genuine. None the less eventually, anti-inflation honour satisfied, the Bundesbank will turn to its second (and very subordinate) objective of 'supporting government policy'.

Considering the deflationary forces at work, however, dramatic moves in interest rates would be necessary to relaunch domestic demand. The Bundesbank will not make them? Very well, the economy will continue to stagnate, and inflation to fall. It may take a long time, but eventually interest rates will reach the appropriate level. If that sounds far-fetched, remember that there is a precedent. In the early 1980s, with the German economy in recession, the new CDU government applied a tight pro-cyclical fiscal policy that shrank the federal deficit from 4 per cent of GDP to 1 per cent over five years.

During that period the cumulative growth of real domestic demand in Germany was less than 1 per cent. In that period, of course, Ronald Reagan unleashed his expansion and exports saved the German economy. This time only interest rates can do it.

Any standard macroeconometric model of the German economy would produce the result that interest rate cuts of about 3 percentage points would be necessary to counteract the deflationary forces I have enumerated. In other words, German interest rates have to fall below 4 per cent, perhaps to near 3 per cent.

If that is not convincing, consider the chart relating the slope of the German yield curve (10-year bond yields minus call money rates) to real GDP growth. The yield curve is a very good indicator of the stance of monetary policy in Germany and, as the chart shows, an outstanding leading indicator for GDP growth (except in 1989-90, the period of the unification shock).

To achieve GDP growth in the range of 2-3 per cent, the yield curve probably needs to have a positive slope around 2-3 per cent. With 10-year bond yields in Germany in the region of 6 per cent, that implies short rates must fall to around 3-4 per cent.

It is a good bet that this will happen sooner or later, probably by this time next year. Other Continental economies will also reduce rates, perhaps not quite so far, but probably sooner. Would the UK government stand by while interest rates, currently 75 basis points below those in Germany, were beached 250 basis points above? That could drive sterling back into its old ERM band against the mark and other currencies. It seems most implausible. So UK rates, too, are going lower - even if the November Budget is less tight than currently threatened.

The author is chief economist at Lehman Brothers and Associate Professor, London Business School.

(Graph omitted)

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