View from City Road: Bundesbank's dilemma on interest rates

Poor Helmut Schlesinger, the Bundesbank president who retires at the end of September, is having an unhappy last few months in office. The Buba has always hated a sagging currency, but the mark is now the victim of a serious run.

Its fall by eight pfennigs against the dollar to DM1.70 in just 10 days is cancelling out some of the anti-inflationary benefits that its previous rise against the pound and other European currencies brought after Black Wednesday.

With German inflation still at 4.2 per cent, the highest in the Group of Seven industrial countries - yes, including Italy's 4 per cent - the monetary hawks of Frankfurt must be seriously considering whether they need an interest rate rise rather than a cut.

The tactical question for the Buba must now be whether a rate rise would prove as counter-productive as it did in Britain in September. Would the markets really believe that it could be sustained when German industrial production has fallen even faster than Britain's?

The strategic question is whether the Buba should even try. Some of the mark's rise and now fall against the dollar is merely cyclical, as Otmar Issing argued yesterday. Recession points to lower interest rates in Germany, while recovery indicates higher ones in the US.

But the foreign exchanges are also like other asset markets. They tend to overreact. Most competitiveness measures, such as those in the graph, show that the real value of the mark has overshot its long-run value sharply since the Berlin Wall came down in 1989.

This was the response, entirely expected by standard theory, to the interest rate rises that the Buba imposed to staunch the inflationary pressures of unification. But the theory also supports common sense - what goes up must come down.

(Graph omitted)