A New Economic Miracle: Lower German Rates?

For months, news from the 12th-floor executive suite of the Bundesbank's headquarters in Frankfurt has been as grim as the building's concrete-and-glass facade. Despite faltering European economies, Germany's inflation-obsessed central bankers ratcheted interest rates higher and higher--until their discount rate reached a record 8.75%.

But now, the bankers seem to be on the verge of a critical policy shift, one that could spark a European recovery. In an Oct. 5 interview with BUSINESS WEEK, Bundesbank board member and chief economist Otmar Issing said the bank had given up on its goal of trying to hold money growth, now running at 9%, to just 5.5% this year. Issing, like Bundesbank President Helmut Schlesinger, is a hard-money conservative and a member of the inner council of five full-time directors. Issing is also remarkably upbeat on Germany's battle against inflation. "The treatment is not yet finished," he says. "But we have been successful in bringing down inflationaryexpectations."

Many European money mavens now expect the Bundesbank to start pushing money-market rates downward. They expect the bank to keep shaving rates on short-term money--now at 8.9%. They also believe a benchmark discount-rate cut could come in the next several weeks. That will begin a series of moves that could lop two percentage points off German rates, taking them down to 7% by the end of next year. "Once the Bundesbank starts," says Lothar Weniger, financial-market strategist at Salomon Brothers in Frankfurt, "they always cut pretty aggressively."

If correct, this prognosis would be welcome news, especially for Europe, whose sinking economies have been hog-tied by the need to match high German rates. While not a cure-all, lower German rates would let Britain's beleaguered Prime Minister John Major cut British rates without sparking another disastrous run on the pound. They would also give French President Francois Mitterrand's unpopular government a chance to attack double-digit unemployment. And German rate cuts would give Washington and Tokyo added room to kick-start their own economic engines.

As recently as Sept. 14, a seemingly insensitive Bundesbank responded to the European currency crisis with a measly 0.25% cut in its Lombard rate. But now, it seems to have taken its blindfold off. The bank admits that high interest rates and the soaring mark are squeezing German industry and making its exports uncompetitive. "We're in a situation where our exports are comparatively weak," says Issing. "We have to fight for market share even more than before."

The change of mood has been noticed by European bankers. "Inflation is not the No. 1 enemy," says Alois Bischofsberger, chief economist at Credit Suisse. "It's deflation, recession, even depression." But he and other bankers caution that the Bundesbank is a stubborn institution and will not want to look as if it is being stampeded by political pressure. To Bischofsberger, that means the Germans are unlikely to cut rates before the European Community meets in Britain at a special Birmingham summit on Oct. 16. But clear prospects of such cuts could help salvage the EC's stalled drive toward monetary and political union.

ALREADY HURTING. There are powerful incentives for the Bundesbank to move soon. Since early September, the mark has risen 5.6% against other EC currencies--squeezing German exports and company profits hard. Because half of Germany's economic output goes into exports, analysts figure that 1992 corporate earnings will be up only 1% over last year. Large swaths of German industry, from machinery to steel to chemicals, are already hurting. Unless some stimulus is added, the overall economy may not grow at all after the slim 1.5% growth projected this year. Already, Daimler-Benz's Mercedes unit says it will speed up a planned reduction of 20,000 workers, and steelmaker Krupp is laying off 1,500 employees. "We are in a fragile situation," concedes Issing.

While the Bundesbank still worries about high wage settlements, the flagging economy is starting to moderate some demands. Unions at money-losing Lufthansa agreed in September to give up all raises next year. The high mark is also helping to hold inflation to an annual 3.5% rate--improving the Bundesbank's mood. Import prices are down 4.5% so far this year.

The bank has already done some minor rate cutting. When money-market rates rose in late September, it pulled out all the stops to push them down to 8.9% again. That's still high--but nearly a full percentage point below the late-summer peak. And it's certainly an about-face, after over four years of rising rates.

THE VIEW FROM THE BUNDESBANK
      Otmar Issing, chief economist and a director at the Bundesbank, talks about the 
      German economy and monetary policy:
      ON GROWTH
      "The real side of the German economy has worsened. We are in a fragile 
      situation."
      ON MONEY SUPPLY
      "We openly admit that we won't fulfill our target this year. That's gone."
      ON A "TWO-SPEED" MONETARY SYSTEM
      "I think for the EC as a whole, it would be disastrous to say to various 
      countries, you and you will not be allowed to take part. This kind of 
      arrangement would really stress the EC, perhaps to the point of existence."
      ON INFLATION
      "The treatment is not yet finished, but we have been successful in bringing 
      down inflationary expectations. I'd like to stress this point."
      ON EXPORTS
      "We're in a situation where our exports are comparatively weak. Price 
      competitiveness within the EC has worsened for us."
      DATA: BW