German bank cuts key rates World markets soar

dollar strengthens

September 15, 1992|By Ian Johnson | Ian Johnson,New York Bureau

NEW YORK -- Germany's central bank cut two key interest rates yesterday in a concession to trading partners that could help European unification but also weaken the bank's reputation as a bedrock of economic stability.

After resisting interest rate cuts for more than a year, the bank decided that a combination of economic and political pressures from its trading partners were too much to withstand and made slight cuts in its Lombard and discount rates.

The moves sent stock markets higher worldwide and strengthened the value of the dollar in international currency exchanges.

Despite the economic effects, the main reason for the cuts were political, said Carol Stone, a senior economist with Nomura Securities International.

This Sunday, France votes on a crucial referendum that could determine whether Europe unites. Opinion polls show that one reason French voters might torpedo European unity is the fear that Germany would dominate Europe as autocratically as it currently runs monetary policy.

Yesterday's rate cuts could help allay French worries by showing that Germany has learned to take its neighbors into account, Ms. Stone said.

"The Germans show that they definitely do not want to bury European integration," said Kurt Lewin, an international economic consultant based in New York.

U.S. officials also welcomed the decision by the German central bank, or Bundesbank, because a stronger European economy will mean more demand for U.S. exports. The cuts could also give the Federal Reserve more leeway to lower interest rates to help stimulate the sluggish U.S. economic recovery.

Germany should also become less attractive to investors, who generally flock to currency that offers stability and the highest rate of return. This had caused investors to dump dollars, with the greenback hitting record lows two weeks ago. Analysts believe that with the dollar stronger, U.S. interest rates could be further cut without causing a new plunge.

Yesterday's news caused the dollar to bounce back against the mark, finishing trading in New York at 1.4883 marks. Earlier this month, it hit a record low of 1.3860.

Stocks also rallied strongly, with the Dow Jones industrial average closing up 70.52, or 2.1 percent, at 3,376.22.

Despite the furious trading spawned by the cuts, the moves by the Bundesbank were extremely modest. The internationally sensitive Lombard rate, an emergency fund rate for the commercial banking system, was cut to 9.5 percent from 9.75 percent. The less sensitive discount rate, at which commercial banks normally borrow from the central bank, was reduced to 8.25 percent from 8.75 percent. The reductions were part of a package to stabilize European currency rates that included the devaluation of the Italian lira by 7 percent.

European leaders such as European Community President Jacques Delors and economists said that for the cuts to be more than gestures, they would have to go deeper in coming weeks.

"In the short term it will help, but it's more of a symbolic move," said Jean-Marie Eveillard, president of Sogen International Fund, investment firm.

The cuts theoretically could allow Germany's neighbors to cut their rates, too. The rates of most West European countries are tied together through the Exchange Rate Mechanism, which allows rates to fluctuate only slightly. This meant that when the Bundesbank raised interest rates over the past two years to control the costs of German unification, its neighbors were forced to follow suit. Now that Germany's rates are falling, its neighbors' rates could also follow.

The hitch is the French vote. If France votes against European unity, the accompanying uncertainty over Europe's future could

send investors to the safe haven of the German mark. This could force other European countries to keep their interest rates high.

A yes in France could restore confidence and, along with the Bundesbank's decision, allow Exchange Rate Mechanism countries to cut rates and boost their economies.

According to the German bank, the cuts were caused by the free fall of the Italian lira, which was trading beneath its limit in the Exchange Rate Mechanism. This was forcing the bank to sell marks and buy lira in an attempt to bolster the Italian currency. The flood of marks in the market was precisely what the bank had been trying to avoid with its tight-money policy.

"We had to get ourselves free of this trap," Bundesbank President Helmut Schlesinger said.

While the bank's ability to admit a mistake and correct it was welcomed, some questioned why the bank had forsaken its iron determination to fight inflation at all costs. All three of the Bundesbank's chief criteria -- inflation, money supply and credit demand -- are significantly higher than bank targets.

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