Bundesbank discount rate cut disappoints: Devaluation speculation mounts as french franc nears floor in exchange rate mechanism

THE BUNDESBANK yesterday cut its key discount interest rate by half a percentage point to 7.5 per cent. But the currency markets were disappointed at the size of the reduction, pushing the French franc towards its floor in the European exchange rate mechanism.

The cut in the official rate which forms a floor for money market rates, the Bundesbank's second in six weeks, was encouraged by a marked slowdown in German money supply growth. It confirmed the central bank's commitment to a steady easing in monetary policy.

However, the decision to leave the Lombard emergency funding rate unchanged at 9 per cent emphasised the Bundesbank's caution. 'One could not expect it to do any more because of the fear for the mark's exchange rate value,' said Ulrich Beckmann, of Deutsche Bank.

The move left the Bundesbank's 'repo' interest rate - most closely linked to market rates - unchanged halfway between the Lombard and discount rates at 8.25 per cent. Paul Chertkow, currency analyst at UBS Phillips & Drew, said the 'repo' rate would have to be cut today to prevent serious pressure building up on the French franc. The Bundesbank's apparent caution suggested German rates would not come down quickly enough to allow the franc to remain at its current parity in the system.

The franc weakened yesterday to close at Fr3.4080, less than two-and-a-half centimes from its ERM floor and a whisker away from the ERM 75 per cent 'divergence indicator' at which central banks are supposed to take action to defend their currencies. Market operators were surprised that the Bank of France had not launched a support-buying operation.

Speculation on a franc devaluation is expected to mount in coming weeks, with the incumbent Socialist government in Paris facing a heavy defeat in Sunday's national assembly election. The defence of the franc has kept French interest rates at 11.5 per cent despite rising unemployment.

German industry also reacted with disappointment to the Bundesbank move, saying the cut was too little given the harshness of the recession.

The move followed hard on news that the broad measure of money supply M3 - cash and bank accounts - had contracted at an annualised rate of 0.1 per cent in February. More important, the bank said M3 had grown at an annualised rate of 5.5 per cent over the past six months, in the middle of its 4.5-6.5 per cent target range.

With the German economy firmly in recession and a recent wave of miserable company results further darkening the prevailing gloom, the Bundesbank has been under enormous pressure to cut rates. The German finance minister, Theo Waigel, said the decision 'will give a positive stimulus for economic growth in a difficult situation'. But the Federation of German Chambers of Commerce dismissed the cut as 'largely symbolic'.

The discount rate is heading steadily for between 4 and 5 per cent, according to Martin Hufner, of Bayerische Vereinsbank, but in achieving this the Bundesbank will stick to its cautious, finely balanced and very clever course.

'From week to week, from one central bank council meeting to another, we can expect some form of decision, some mix of the various instruments,' said Uwe Angenendt, of BHF.

The room for German rate cuts has grown in recent weeks as all of the Bundesbank's pre-conditions for monetary easing have been fulfilled to varying degrees. Inflation is falling, albeit slowly, wage settlements have been moderate, the political logjam over financing unification has been broken by agreement on a solidarity pact, however controversial its contents, and money supply growth has cooled dramatically.