Irish borrowers may well be confused by the latest events on interest rate markets. Usually a German rate cut would feed through to lower Irish interest rates. But yesterday a round of retail interest rate increases started in Ireland on the very day German rates fell.
The size of the Bundesbank reduction took the financial markets unawares. They had been expecting a 0.1 to 0.2 of a percentage point cut in German money market rates. In the event, the German central bank reduced rates by 0.3 of a point. Irish Permanent increased rates by 0.25 of a point yesterday and other institutions are expected to follow. If the Bundesbank had not cut, the increase would probably have been a full half point. The Central Bank's motivation for pushing interest rates higher appears to be to slow credit growth and cool the housing markets. Whether a quarter point increase will help to do this is open to question. It also sends Irish interest rates in the opposite direction to European rates. The news from Germany should, nonetheless, limit the size of the Irish interest rate increase over the longer term. All this shows the dilemma facing monetary policy which must try both to manage the domestic economy and to keep Ireland in line for monetary union.
The reduction may have been warranted by German economic conditions. However the Bundesbank's principal target appears to be the currency markets. It wishes to see a weaker deutschmark in part to boost the German export sector. The motivation may also be political. The Bundesbank was under pressure to give a vote of confidence in monetary union and assist the French franc. The French central bank gratefully reduced its rates yesterday and the franc now looks more stable on the currency markets.
Where it has a choice, the Bundesbank has recently tended to surprise in the direction of support for the agreed timetable in the transition to monetary union at the beginning of 1999. On this occasion, the decision to reduce the main money market rate will help to stimulate growth. This prospect is made more likely by surveys of business opinion and, according to Dr Hans Tietmeyer, by analysis of the latest German money supply figures. Renewed economic growth would greatly ease the pressure most EU governments have been put under by the need to adhere to the Maastricht criteria on economic convergence. The French government, in particular, faces a very difficult autumn of protest as it seeks to freeze or cut social programmes.
Another longer term trend affecting the German economy is the strength of the deutschmark compared to other major currencies. There has a been a series of complaints by prominent business spokesmen that the burden is unsustainable given the existing costly German social infrastructure. In the short term the effect of this rate reduction will be to strengthen the dollar and hence sterling on the foreign exchanges. Looking ahead, it would be foolish to underestimate the resulting momentum in favour of monetary union, driven by fundamental economic interests, quite aside from the more volatile movements of public opinion and renewed scepticism about surrendering the deutschmark the most potent symbol of Germany's post war success and sovereignty for a common European currency.
The fact remains, however, that the Irish and German economies are at polar opposite points in the economic cycle, which requires quite different responses in managing them. This raises the question of what will happen, if and when, this State is deprived by monetary union of the mechanism of interest rate rises to cope with potential domestic inflationary pressures.