Understanding the German Rate Cut
Stock markets around the world rose on the surprise news that Germany would lower two key interest rates. Here is a look at the forces behind the action and the likely effects:
BACKGROUND
Germany’s central bank, the Bundesbank, has been resisting calls from other countries to lower its interest rate. The last rate cut was nearly five years ago. Inflation has been rising in Germany, fueled by its spending spree on reunification. Other European nations, meanwhile, have seen their economies stagnate but they can’t lower interest rates because it would weaken their currencies and boost inflation. Politics played a big role. On Sunday, French citizens will vote on the Maastricht Treaty, a plan for European monetary union and political cooperation. Germany was afraid of a ‘no’ vote by the French, who are angered by what they see as the Bundesbank’s lack of concern for the economic fate of Germany’s neighbors. Germany did not want to be blamed for the Maastricht Treaty’s demise.
THE EFFECTS
When German interest rates go down, the dollar goes up. Investors seeking a higher return will move out of German bonds and into dollars, boosting the value of the U.S. currency. On Monday it cost up to 1.5 marks to buy a dollar, compared to 1.45 marks on Friday.
A higher dollar slows U.S. inflation, because $1 today buys more from Japan or Germany than it did last week. That translates into lower prices on imported goods like Japanese cars or German machinery. The lower German interest rate may signal further reduction in U.S. interest rates. The Fed, which has been lowering rates to spur the economy, has been cautious about making further cuts because it could lead to higher inflation. Monday’s action in Germany reduces the inflationary risk. With inflation less of a concern, European countries and Japan can also lower their interest rates. That will stimulate their faltering economies and create demand for American goods. Although the higher dollar makes U.S. goods more expensive, economists say slow demand overseas, not higher prices, has been the real obstacle to increasing U.S. exports. The U.S. economy could grow. Companies can borrow at a lower rate to build new factories, invest in training and enter new markets. Lower interest rates can also encourage people to buy houses, which also boosts economic activity in everything from construction to furniture sales.
How World Rates Diverged While the United States and Japan have been cutting interest rates since 1990, Germany had continued to raise key discount rates on bank loans-until Sunday, when the German central bank finally relented in the face of a weakening European economy. Central Bank Discount Rates United States: Sept. 1992: 8.25% Germany: Sept. 1992: 3.25% Japan: Sept. 1992: 3.00% Source: Salomon Bros.
