View from City Road: France should grasp the nettle and cut rates

Cross-channel holidaymakers should not get too excited about yesterday's quarter point off the French overnight money market rate. The move was intended to put very short-term rates closer in line with official rates, unwinding one of the protective mechanisms the Bank of France has employed against currency speculators.

In one sense, it was the bank putting a toe in the water to see the effect on the franc of a slight easing. (It fell.) It is possible that we may look back one day to see it as the beginning of a slide in French interest rates. But it is certainly not a signal of a rapid slashing, British style.

The British government, to its credit, was able to recognise within days that departure from the exchange rate mechanism had led it into a new world, and reacted accordingly. There is no sign that the French government has abandoned its strong franc policy, to which it has been committed for far longer than the British government's brief sojourn in the ERM.

This is not simply political sclerosis, or an inability to accept that the environment has changed. The French government has a rational policy of remaining in the inner monetary core of Europe with the Germans and Dutch, and does not want to throw away the opportunity of rejoining them. Unfortunately it is misreading the markets.

The franc is at risk of a sell-off not because it is over-valued at the moment but because its high interest rate policy is driving production down and unemployment up. The markets do not believe France can stand the strain for much longer, and are duly discounting rate cuts.

The clearest proof of this would be if a significant lowering of rates strengthened the franc. But it would not be a very scientific experiment. It is just as likely that the short-term reaction would be a sharp fall in the French currency, with a delayed recovery as the economic indicators improve. This is precisely the British pattern: sterling was 16 per cent lower than its Black Wednesday level in May, but its recent rebound means that the devaluation has been cut to 10.6 per cent.

In Paris, caution may prevail, not least because of an adverse short- term reaction to the first interest rate cuts. But common sense says the French should get on with lowering rates and let the currency find its own level for a few months. Imagine the state of the domestic economy if the government is forced to defend another run on the franc in the autumn with higher interest rates as its only weapon. After all, there is precious little left of France's official foreign currency reserves.

But if France grasps the nettle, it is a reasonable bet that by the turn of the year the franc will be stronger than now, and at negligible inflationary risk, given the depth of the downturn. In the meantime, we are unlikely to see any substantial reduction in the cost of French money or in the value of the franc until after the holidays.