Comment: Things may still go horribly wrong

It ought to be all right. The Bundesbank move yesterday sounded fierce, as it was meant to, but in reality it was almost the least it could do given the pressures it was under. However, there is a world of difference between what ought to happen on international financial markets and what does happen, so there remain serious dangers ahead.

To understand the context of the Bundesbank's move, one has to look at the ways in which its two key interest rates, the discount rate and the Lombard rate, affect other interest rates. The discount rate sets the floor for other rates, but is largely inoperative at the moment, for there is no question of rates coming down. It does affect certain administered interest rates, such as that on some subsidised loans made to people in the former East Germany, but it does not have any immediate influence on the rates in the money markets.

Putting the discount rate up by 0.75 per cent seems slightly tougher than the markets had expected - a 0.5 per cent rise would have been more in line. But apart from putting up the price of the subsidised loans, and perhaps giving a signal that rates will not come down for some time, it does not mean much.

The Lombard rate, on the other hand, does directly affect money market rates, for this is the ceiling under which the Bundesbank feeds money into the markets. By keeping that where it is and, equally important, not restricting the access of banks to borrow at that rate, the Bundesbank is saying that it genuinely does not want money market rates to rise. It follows that there should be no need to increase UK base rates to match.

The problem with this rational line of argument is twofold. In the first place, a number of other countries, including Belgium, the Netherlands and Italy, have all increased some interest rates by varying degrees, making Britain appear the odd man out. This response can be explained by the individual situation of the countries concerned: Belgium and the Netherlands have long shadowed German monetary policy and are really part of a narrow DM bloc. Italy had grave budgetary problems, a clearly overvalued currency, and a less-than-stable government. Intellectually there may be no link between the position of these countries and Britain, but it does not look very good to hold rates when other countries are moving theirs.

The balance of probability is that once the markets have digested this information they will settle down. Sterling will remain near the bottom of its trading range through the summer, but it will be possible to hold it above the floor without a rise in base rates. And towards the end of the year Germany will start cutting interest rates and it will be possible to start moving British rates down, too.

That is, however, only the balance of probability. There must remain a possibility, somewhere between 10 and 49 per cent, that things will go terribly wrong, that there will be run on the pound and that base rates will have to rise to stop it. This could happen at any stage between now and that first fall in German interest rates.

It is difficult to be optimistic about the pace of economic growth through the summer and autumn against this background. Even if interest rates do not rise, the distant fear that they might will tend to hold back confidence, both of consumers and of the business community. At worst these fears will lead to a double dip in the recession.

Looking ahead, there are two broad scenarios for the economy this year. That double dip is the less attractive. Technically there is little doubt that the bottom of the recession was reached in the first quarter. But the recovery so far is so weak that there is nothing for the industrial sector to build on. If companies have planned on a rise in demand this summer, and then do not see one, they may cut back yet again. The second leg of the recovery would then not be evident until well into 1993.

The more hopeful scenario is that the very ferocity of the recession has forced companies to cut their costs so much that they can increase sales while holding or even cutting prices. It is very simple maths, but if consumers have pounds 250 to spend on a TV and the TV comes down in price to pounds 240, that leaves pounds 10 to be spent on something else. The lower the increase in retail prices, the more any increase in spending translates into an increase in real output.

The evidence yesterday in the earnings figures does show that industry seems at last to have succeeded in squeezing down the rate of growth in money wages below the 7-7.5 per cent range, which seemed the floor thoughout the 1980s.

Enthusiasts for the discipline of the exchange rate mechanism might attribute this change to ERM membership. Opponents would say it is simply the result of the depth of the recession. But something does seem to have changed.

Or rather, it has started to change. In the months ahead events will occur which will give a new impetus to the 'leave the ERM' brigade, even assuming there is no rise in base rates. These could include bad trade figures. They will almost certainly include bad unemployment figures, for that very small rise last month looks too good to be true.

The bad news could come from the United States, where the business community is starting to take the Clinton challenge seriously and feeling uncomfortable about the consequences. Or it could come from Japan, where the financial system remains extremely fragile.

What is almost certain is that the sort of tension that struck both the financial markets and British politics in the last few days will strike again. It has been fascinating to see just how quickly an anti-ERM coalition has been stitched together from completely different political strands: much of the Labour party and its supporters, a significant segment of the Tory anti-European wing and some sections of industry (though not usually the more successful ones).

The view of the broad centre remains that membership of the ERM at this rate is either the least unattractive option, or a positive advantage in that it is forcing a rapid adjustment in inflationary expectations. But being in the centre is uncomfortable, and will continue to be in the months ahead.