The Road to monetary union appears much less smooth and predictable now that the Bundesbank has signalled a possible change in German monetary policy. Such a shift could lead to higher interest rates.

Very few market observers had expected it. Most rooted for May next year or even 1999 as the start of new cycle of monetary tightening.

What happened last week was a subtle warning by the Bundesbank that it may change the way it injects money into the economy. Its favoured instruments are the fortnightly securities repurchase tenders, which it currently offers at a fixed rate of 3 per cent.

The Bundesbank did not raise this rate last week, but said it would only commit itself to two more fixed-rate tenders. After that, it might switch to variable-rate instruments, meaning it will accept the highest bids for any given amount of money. The practical consequence of this is that financial markets will probably bid up short-term interest rates from the current 3 per cent level.

Some currency experts believe the central bank may be bluffing. But almost everybody agrees that the warning was intended to stop the relentless slide of the D-Mark against the dollar, as speculation against the German currency is increasingly seen as a one-way bet.

The view that German monetary policy may have changed last week is shared by a series of currency strategists in London and New York. The arguments in favour of a shift fall into three broad categories:

The exchange rate. The Bundesbank perceives the deutschmark as undervalued at current parities. But the real problem is not so much the current level of the exchange rate as the possibility of a further slide.

The domestic economy. The German economy has turned the corner with a vengeance. It is already growing at a robust rate and may be heading for 3 per cent next year, according to some forecasts. What worries the Bundesbank is that inflation is heading above 2 per cent next year.

The transfer of power from national central banks to the European Central Bank (ECB). The argument for raising rates now is to relieve the ECB from drastic action on rates during its first year of operation. Higher rates would smooth the transfer.

However, the de facto devaluation of the deutschmark has been seen in the markets partly as a consequence of persistent high EU unemployment. Under EMU, a memberstate will not be able to devalue its currency. The recently agreed stability pact, which seeks to limit government deficits to 3 per cent of gross domestic product, virtually rules out fiscal policy as a job-creating mechanism. With relatively inflexible labour markets, there is little left but the external exchange rate of the euro - or the deutschmark until 1999 - to act as a shock-absorber.

If the Bundesbank was to drive up interest rates at this point, it might limit the extent to which Germany and other EU memberstates can reduce their persistently high rates of unemployment.