The Bundesbank said the Discount rate, the lower of a two-tier rate structure which places a floor under German market rates, would be lifted an unexpectedly tough three-quarters of a point to 8.75 per cent. But bowing to intense foreign pressure, the majority of the 18-man council resisted calls from a hawkish minority to raise the more internationally sensitive Lombard rate, the ceiling for market rates.
The Discount rate has increasingly been exploited to provide cheap credit to eastern Germany and the Bundesbank indicated that the increase was aimed at curbing that expansion of credit, without provoking general interest rate increases across Europe.
Germany's central position in the European Monetary System (ERM) meant an increase in the Lombard rate, now 9.75 per cent, would have automatically forced up leading rates in Britain and other countries in the system.
In spite of the Bundesbank's diplomatic gesture, its stance against perceived inflationary pressures led analysts to conclude that there was virtually no chance of a cut in the Lombard rate until the turn of the year at the earliest.
A cut in British mortgage or base rates - 10.7 per cent and 10 per cent respectively - before then is almost impossible without risking the pound's stability. Ministers accepted last night that if the Bundesbank decision did not lighten German inflationary pressures, the Lombard rate could still rise. Yesterday's move was seen as welcome but not an all-clear.
The pound dipped sharply, losing more than 1 pfennig on Wednesday's close, but regained its poise after it became clear that no economically crippling rise in British rates was imminent. But Italy and Austria raised some key rates to steady their currencies against the mark.
In London, sterling ended 1.9 pfennigs higher at DM2.8640. There was no sign of Bank of England intervention yesterday, but it has emerged that the Bank quietly steadied the pound in the past two weeks after some Tory critics, notably Baroness Thatcher, advocated devaluation.
The Prime Minister and Chancellor of the Exchequer greeted the impact of the Bundesbank decision with heartfelt relief.
The Government was further heartened by two pieces of surprisingly good news. Unemployment showed its smallest rise for two years in June, while average earnings were shown to be growing at their slowest rate for
25 years in the year to May.
Treasury sources reaffirmed that devaluation was not on the agenda, commitment to the ERM was unqualified, and sterling would eventually move into the narrow ERM bands 'at the current rate' of DM2.95.
Helmut Schlesinger, the Bundesbank President, attempted to calm fears that it sought a revaluation of the mark against other ERM currencies. He added: 'It is my opinion that those countries who are currently in difficult positions, and do not want to devalue, should see this as an anti-inflationary measure.' Mr Schlesinger said the Bundesbank had sought to balance its domestic difficulties against international concerns.
He emphasised the inflationary dangers of the surge in money supply growth - reflecting the rapid expansion of government subsidies to eastern Germany - and reasserted the Bundesbank's goal of crushing inflation from 4.3 per cent to zero.