German 'repo' cut fuels UK hopes of lower rates: Bundesbank paves way for reduction in discount level to rescue franc and ERM

AN UNEXPECTEDLY large cut in the German 'repo' interest rate yesterday eased tensions in the European exchange rate mechanism and fostered speculation that the Chancellor, Kenneth Clarke, may soon cut interest rates again in Britain.

Hopes of a British rate cut, perhaps as early as tomorrow, saw the September short sterling futures contract close 18 basis points higher at 94.36, suggesting that the market expects base rates to be around 5.64 per cent by the autumn. But the three-month interbank rate - which tracks base rate expectations - was less active, closing at 57 8 per cent. Base rates were last cut, to 6 per cent, following bad unemployment figures in January.

Hopes of a rate cut and a positive mood in the gilts market overcame fears earlier this week that yesterday's gilt auction would go badly. The auction was covered 2.29 times, with pounds 7.43bn of bids chasing pounds 3.25bn of stock.

The stock market closed slightly higher on the day, helped by rate hopes. The FT-SE 100 share index closed 4.8 points stronger at 2,884.4, having been pulled from its 2,895.7 peak by weakness on Wall Street.

City analysts said the odds were still against an early rate cut, but that it could be justified by Tuesday's gloomy survey from the Confederation of British Industry and by falling expectations for inflation. Gordon Brown, the Shadow Chancellor, said: 'In the light of today's action by the Bundesbank I am reiterating my call for a British interest rate cut.'

The cut in the German repo rate from 7.15 to 6.95 per cent was expected to foreshadow a cut today in the key discount rate, the floor for German money market rates.

Most analysts expect the Bundesbank to cut the discount rate by half a point to 6.25 per cent, although some believe the cut may be as large as a full point.

The growing conviction that the Bundesbank will cut rates to help salvage the ERM allowed the French franc to climb away from its floor in the system. After trading for a while above Fr3.40 to the mark it closed at Fr3.4045, a centime up on the day and 2.6 centimes from its ERM floor.

The Bank of France was also rumoured to be supporting the franc, and the Belgian central bank intervened in support of its currency, which came under pressure but closed virtually unchanged on the day. The Danish krone was comfortable.

Six leading economists argue in the Financial Times today that European Monetary System countries are repeating the mistakes of the 1930s, and should accept the demise of the EMS as the price for tackling unemployment. They call for reflationary policies, beginning with a sharp cut in interest rates, and say EMS countries should accept that their exchange rates will fall below their lower limits in the ERM.

Olivier Blanchard, Rudiger Dornbusch, Stanley Fischer, Franco Modigliani, Paul Samuelson and Robert Solow of the Massachusetts Institute of Technology say France should lead the way by slashing rates and letting the franc float.

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