Interest rate fears calmed as German inflation falls

The western German cost of living index steadied in July and the annual inflation rate dropped from 4.3 per cent in June after a sharp increase in petrol taxes dropped out of the comparison.

The fall is significant because Germany's inflation rate is effectively the UK government's target. The drop puts German inflation below the British rate, which stood at 3.9 per cent in June, for the first time since January. On a comparable underlying basis the UK inflation rate - excluding mortgages, as in Germany - was 4.8 per cent.

The better-than-expected German figures were also helped by lower prices for food and energy, due in part to a rise of roughly 5 per cent in the mark against the dollar.

While the stronger mark reduced import costs, German inflation figures were also helped by weaker dollar-based prices for oil in July. Prices were also held in check by a steep fall in seasonal fruit and vegetable prices.

Fears in the Frankfurt market that the Bundesbank could yet follow up its recent increase in the discount rate to 8.75 per cent with a further rise in the more crucial Lombard rate, now 9.75 per cent, have faded. But the likelihood of a reduction in German rates remains slight until the end of the year at least.

Analysts expect western German inflation to range between 3.3 and 3.5 per cent in the coming months. But in January the Bonn government plans a 1 percentage point increase in value-added tax to 15 per cent to meet European Community harmonisation rules and finance rising public spending.

The VAT increase could send inflation back above 4 per cent in January. The Bundesbank, aware of the planned increase in VAT, has nevertheless made it clear that it wants to see a sustained fall in the inflation rate, with an ultimate target of zero. This implies that it will maintain a tight monetary policy for the next 18 months.

While hopes continue that the Bundesbank will begin to cut its key rates in the new year, the German central bank is not expected to make any significant cuts for 1993 as a whole.

In addition to easing inflation, the Bundesbank has made it clear that it also wants to see slower broad money supply growth. The latest figures showed that M3 slowed slightly to an annualised rate of 8.7 per cent in June from the average growth in the fourth quarter of 1991, against 8.8 per cent the previous month.

The Bundesbank's target for annualised M3 growth is between 3.5 and 5.5 per cent. Analysts believe that M3 is now beginning to slow, but at a very gradual pace, and is unlikely to fall within target until well into 1993.

Meanwhile, the five eastern German regional states and Berlin yesterday called for extra funding of DM50bn (pounds 17.6bn) from the central government and the western states to keep them afloat in 1993 and 1994. If the money was not available higher taxes should be introduced, they suggested.

Georg Milbradt, Finance Minister of Saxony, said that unless the DM50bn was forthcoming the eastern states would be saddled with impossibly high debt levels at an early and sensitive stage of their development.

According to figures presented to the Finance Ministry in Bonn, the eastern states and Berlin calculated that the shortfall from revenues next year would be DM14bn and, in 1994, DM24bn. That aside, they said they needed a further DM12bn to finance essential infrastructure projects such as old people's homes and hospitals.

In a frosty response to the request, Theo Waigel, Germany's Finance Minister, said yesterday that he had already set aside DM92bn for the eastern states in next year's budget and the highest priority now was to stabilise the country's finances.

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