Recent speculation that the Bundesbank may be poised to lift some interest rates at Thursday's fortnightly council meeting, despite intense international concern, yesterday drove sterling and the dollar sharply lower against the mark.
The pound came under particularly strong pressure, falling by more than two pfennigs to DM2.8523, close to its all-time low in the European exchange rate mechanism.
The three-month interbank rate, which tracks City base rate expectations, edged up 1/8 of a point to 10 1/8 per cent.
Although sterling was still well above its absolute ERM floor of DM2.78, it was undermined by continuing speculation over devaluation despite the categoric rejection of this option last Friday by Norman Lamont. The Chancellor said then: 'We know from bitter experience that devaluation just does not work for Britain.'
Shares also fell on worries about the Bundesbank. In London, the FT-SE 100 index dropped 12.5 points to end at 2,478.3, while in Frankfurt the 30-share DAX Index fell by 17.98 points to 1,736.5, its lowest close for two months.
Weak British manufacturing figures for May, out today, may contribute to unease that the UK economy has yet to show signs of recovery and provide ammunition for Conservative MPs pressing for further interest rate cuts.
The dollar, meanwhile, sank by 1.63 pfennigs to end at DM1.48 but may gain some relief if today's US retail sales figures help to dispel the impression of a fading American recovery.
In the financial markets leading Bundesbank watchers expect the German central bank to shy away from the most aggressive action available - an increase in the key Lombard rate, now 9.75 per cent - and opt for lesser measures.
Herman Remsperger, of BHF- Bank in Frankfurt, said the Bundesbank could raise the discount rate, an emergency funding facility for banks which now stands at 8 per cent.
This move could be combined with a reduction in the amount banks can borrow at the discount rate, which would make the policy change even more restrictive.
A more extreme option would be to limit the amount that banks can borrow at the key Lombard rate. But these remedies may not necessarily bring about an increase in interest rates elsewhere in Europe, including Britain.
A senior German official yesterday declined to rule out another round of credit tightening. Horst Kohler, state secretary of the German Finance Ministry, speaking after a meeting of European Community finance ministers in Brussels, said the Bonn government was not asking for stricter measures. But he added they would 'accept the decision' of the politically-independent central bank.
Confirming that the debate under way at the Bundesbank was 'very intense', Mr Kohler acknowledged that other EC finance ministers voiced their concern at possible Bundesbank action later this week.
The Bundesbank's chief worry is excessive money supply growth, fuelled by the surge in subsidised credits to eastern Germany.
Bundesbank officials have publicly deplored the latest figures, for May, which show broad M3 money supply expanding at a 9 per cent annual rate compared with the fourth quarter of last year.
The Bundesbank has set a 3.5 to 5.5 per cent annual target range for M3, which it is expected to reconfirm on Thursday.
Those against a further tightening are said to argue that German inflationary pressures are being contained by the strong mark. They also emphasise that M3 growth may be distorted by special factors and may not entirely reflect inflation trends. The money supply expansion partly reflects the rush of funds into high-yielding short-term deposits which are part of the M3 measure.
Some Bundesbank officials are arguing that it is impossible to assess whether excessive monetary growth in eastern Germany is inflationary when the economy is being transformed from a command to a free market system.
Hamish McRae, page 21