Surprise increase in German rates sends world markets lower

The Bundesbank increased German interest rates yesterday, following Alan Greenspan's signal on Wednesday that US rates will rise. The Bank of England left the cost of borrowing in the UK unchanged, but it will follow the international trend before long, predicts Diane Coyle, Economics Editor.

A surprise increase in the Bundesbank's key money market interest rate caught the world's financial markets on the hop, sending bond and share prices lower for the second day running. Although analysts had widely expected German rates to rise, nobody expected it to happen just yet.

The 0.3 point increase in the Bundesbank's repo rate to 3.3 per cent was followed by smaller increases by the French and Dutch central banks. But the Bank of England announced that it was leaving UK rates unchanged at 7 per cent this month.

The German mark spiked higher against the dollar and pound, and there were unconfirmed rumours that a number of central banks had intervened in the currency markets to support the dollar.

The FTSE 100 index in London fell as much as 96 points during the day before ending 44 points lower at 5,217.8. Across the Atlantic the Dow Jones index also dropped 90 points when Wall Street opened, later recovering to be 43 points down at 8,052.33.

It was the second day of weakness after Alan Greenspan, the Federal Reserve Chairman, sent an unexpected signal on Wednesday that US interest rates will have to rise. He described America's economic boom as "unsustainable" because of the tightening labour market.

Figures yesterday showing that new unemployment claims in the US fell to their lowest since early 1989 in the latest four weeks added force to his warning. The figure fell to an average of 306,750 from 308,750 in the preceding four weeks.

The declines in the Anglo-Saxon and European financial markets yesterday followed overnight setbacks in the Asian stock markets. Both Japan's Nikkei index and Hong Kong's Hang Seng fell back sharply, by 1.4 per cent and 4.3 per cent respectively.

Some commentators saw these successive moves as evidence that the financial bubble that has so concerned Mr Greenspan has been punctured. "With the German move following hard on the heel of Mr Greenspan's comments, the decline in the stock and bond markets could be sustained," said Mark Cliffe of HSBC Markets.

Douglas McWilliams of the Centre for Economic and Business Research warned yesterday that the US stock market remained 25 per cent overvalued, and London share prices were 10 per cent too expensive. "There have been only two occasions when US share prices have been this overvalued, in 1987 and 1929," he said. "They are rather unfortunate precedents."

Others, however, were not as pessimistic. Dhaval Joshi, equity strategist at Robert Fleming, said: "Items of bad news can set off a short-term panic and we are seeing an episode of that. But it doesn't have to end in a blow-off."

Michael Hughes of BZW said: "The markets had been getting a little bit ahead of themselves and just found the excuse for a setback."

The Bundesbank's move yesterday was interpreted as a step taken mainly to ease the transition to European Monetary Union, as all member countries will need to converge to the same level of interest rates by the time it starts just over a year from now. Gunter Rexrodt, the Economics Minister, said it showed Germany's determination to maintain stability ahead of EMU.

The German authorities have also been concerned to prevent the mark from falling further, as increases in import prices have reached an eight-year high.

However, most economists did not think the interest rate increase would damage the recovery. "External factors pushed them into making this move, but it should not harm the domestic economy," said Michael Lewis at Deutsche Morgan Grenfell.

Banque de France raised its intervention rate by 0.2 points to 3.3 per cent after the Bundesbank announcement.

However, the Bank of England's Monetary Policy Committee decided yesterday to leave UK rates unchanged at 7 per cent. Minutes of its two-day meeting, showing its debate and how its members voted, will be published six weeks from now.

Many City experts nevertheless expect that it will increase rates by the end of the year. Whether and when it acts will depend on figures due in the next week or so, especially the initial estimate of the increase in GDP during the third quarter.

This is expected to show that growth has not slowed down despite the four small increases in loan rates since the beginning of May. The strong pound has not yet squeezed exports enough to offset buoyant consumer spending fuelled by higher incomes, declining unemployment and the windfalls of free shares from former building societies.

Outlook, page 25.