Commentary: Fear not, for the mark must fall

Even though the United Kingdom is no longer in the ERM, German interest rates are an important influence on policy in this country. Why is Mr Lamont so adamant that he has no plans to reduce interest rates? Not because he is utterly confident that the reductions since last September are enough to trigger a strong recovery. Evidently, what concerns him is that any breath of more rate reductions carries the risk of hot money flowing abroad, more sterling depreciation and more imported inflation.

Some argue that the economy is so depressed that inflation is not to be feared even if more depreciation occurs. The arithmetic, however, says otherwise. If the pound falls, say, 10 per cent, import prices will eventually rise by half that much, around 5 per cent, even making every possible allowance for businessmen being unable to pass on cost increases fully. Imports make up nearly 30 per cent of total expenditures, so that 5 per cent will translate into about 1.5 per cent on the general price level. So, even without any feed-through into wages and back to prices, inflation for a while will be up by at least 1 percentage point. The pound has already fallen by some 15 per cent since last September on a trade-weighted basis. If it falls further, Mr Lamont's target ceiling of 4 per cent for the underlying inflation rate will be in jeopardy.

It follows that he cannot be indifferent to German interest rates. If those fall, he will have room to cut sterling rates, should he need to. If they do not, he can foster recovery only at the cost of his inflation objectives.

In September, the UK was thrown out of jail, but now, five interest rate cuts later, we have used up the room for manoeuvre that being pushed out of the ERM conferred. The good news is that we shall be 'sprung' again, this time by a spectacular fall in German interest rates. Over the next 18 months, the German authorities will cut interest rates by much more than Mr Lamont would ever wish to do. This will enable him (or his successor) to shave UK rates and still see sterling appreciate against the mark and the other currencies still linked to it.

OBSESSIVE FOCUS

There is, of course, a general awareness that German interest rates are finally on the way down. The Bundesbank shaved a key money market rate by a quarter point only on Friday. Interest rates are a full point below their peak of last autumn. The markets and commentators, however, have focused obsessively on the start of this process, asking when will the Bundesbank cut next and how much. They have not focused on the end of the process and asked where interest rates will go in Germany over the next year or more. The markets are currently (and absent-mindedly) betting that German interest rates will fall to about 6 per cent at year end, about 2.5 points below their current level, and will then stay there.

To be fair, that would probably be enough for Mr Lamont. Even if the economy is as sluggish as the Treasury forecast he won't want to cut rates below 3.5 per cent. But, in fact, you can bet Frankfurt to a brick that German rates are going through 6 per cent this year and during 1994 they will probably go through 4 per cent too. Despite the recent talk of sterling's 'free fall', that tumble in mark rates will see the pound back above DM2.5.

The reason is that while the Bundesbank first and foremost concentrates on inflation control, once inflation is falling it is charged with supporting general government policy. German inflation has just peaked, and while it will subside gradually rather than crash, there is little doubt about its direction now that wage settlements are running below 4 per cent and below the inflation rate itself. As the year goes by, inflation will look less of a threat.

The German economy, however, already in recession, will stay in it. Every German recession since the Second World War has been ended by a pick-up in exports, and many German commentators, including those at the Bundesbank, have rather blithely assumed that this one will be no exception. With a slow US recovery, a highly competitive dollar and the whole of Europe yoked into recession by a shared monetary policy, this time there will be no German export boom in 1993 nor in 1994. The recovery must come from domestic demand in Germany itself.

But fiscal policy in Germany is moving to restriction. Unluckily, reunification came at the top of an economic cycle when the West German economy was already experiencing an investment boom. The government had to spend a fortune on the east; it began to run a large deficit, boosting demand and driving GDP even higher. The Bundesbank responded with higher interest rates that succeeded in first cooling the boom and then inducing a recession. Just at this point, worried by the budget deficit, the German government is raising taxes and trying to restrain expenditure in the west. For the best of reasons, fiscal policy is therefore acting pro-cyclically, dampening demand and making the recession worse.

DEFLATION AT WORK

Moreover, in order to 'give the Bundesbank room to cut rates', wages are being restrained. This wages policy is ensuring that real wages fall slightly in 1993 even before higher taxes are taken into account. More deflation. The only force making for recovery will therefore be those lower interest rates. But they must go very low to counteract the deflationary forces at work.

The German economy has never been very sensitive to interest rates. Most mortgage contracts, for example, are fixed-rate with substantial penalty clauses. Most home buyers get little benefit from lower rates, unlike in the UK. Moreover, long-term interest rates are more important than short rates in Germany and 10-year bond yields are already 2 percentage points below short-term interest rates. The yield curve cannot stay inverted through the cycle, so to get bond yields down much further short rates would have to drop some 4 points. These institutional considerations are supported by econometric analysis. An economic model of the German economy, such as the one maintained by the UK's National Institute or London Business School, would predict that a cut of 3.5 per cent in European interest rates now would raise German GDP by perhaps 0.25 per cent this year and just 1.5 per cent in 1994. The scale of necessary rate cuts is evident.

And there is a precedent. In 1981 the Bundesbank cut rates and saw call money fall 4 per cent in a year, although inflation was above 4 per cent, though falling, for much of that time. In 1982, call money fell another 3 per cent.

Unemployment in Germany will rise steeply this year as inflation subsides. It may take weeks or months, but at some point the Bundesbank will begin to panic. They will eventually cut rates enough for the German economy to begin to recover. By the time recovery starts it may be the middle of next year, and interest rates could be at 4 per cent. The markets will begin to anticipate the unfolding of this process before that, however, weakening the mark in advance and surely saving what is left of the ERM. Mr Lamont, too, will be back out of jail.

The author is chief economist at Lehman Brothers International, and Affiliated Professor, London Business School