THE Bundesbank's struggle to balance its desire to achieve domestic price stability against the rest of Europe's need for lower interest rates will remain the most important political story in Europe this year. But the Bundesbank is also engaged in a domestic economic balancing act which may well determine the fate of the French franc and the length and depth of Germany's looming recession. The Bundesbank's tight monetary policy, whether or not it makes sense for Germany, has undoubtedly been inappropriate for almost every other member of the European exchange rate mechanism over the past year. But the Bundesbank has, in fact, been quietly bowing to the pressure over the past six months, despite the hawkish noises from Mr Helmut Schlesinger and other members of the bank's governing council. Short-term German interest rates have fallen by more than a percentage point from their peak last autumn. The main function of last week's headline-grabbing cuts in the discount and Lombard rates was to raise the public profile of the easing of policy that has already occurred over the past few months. Whether or not they also signal that the Bundesbank is bowing to international pressure will depend on whether the bank eases money market rates faster over the coming months than domestic conditions warrant. But, for France, even a faster rate of easing may not be enough. The French problem, as the table demonstrates, is not simply that German interest rates are too high but that the expectation of a franc devaluation has caused the risk premium in French short-term interest rates over German rates to triple since last summer. Yet the Bundesbank is not only under pressure from abroad. As the plight of German industry has deepened, the Bundesbank has come under increasing pressure from within Germany to lower German interest rates and thus reverse the mark's appreciation of the past year. German industry has been in recession since the middle of last year. West German industrial output fell by 0.8 per cent last year, but by 5.1 per cent in November and December compared with the same months in 1991. The weak performance of Germany's export industries constrained the growth of gross national product to 0.8 per cent last year and GNP is expected to fall this year by up to one per cent. Yet while industry has been suffering, the Bundesbank has been struggling with powerful inflationary pressures within western Germany. Gross domestic product grew twice as fast as GNP last year and the annual inflation rate has risen to 4.4 per cent in January. The reason for this German stagflation - falling output combined with rising inflation - is illustrated in the chart. Sluggish international demand and the appreciation of the mark have prevented German industry from raising the price of industrial goods. The annual rate of producer prices inflation has been falling steadily throughout the past two years, to less than 0.5 per cent by the end of last year. But the costs that industry face have risen much faster. Average wages rose by six per cent in 1991 and by 5.4 per cent last year as the combination of consumer spending and the growing fiscal deficit, 4.1 per cent of GNP in 1992, have pushed service price inflation to more than six per cent a year. The chart explains the Bundesbank's dilemma. Easing monetary policy now and allowing the mark to depreciate would fuel these domestic inflationary pressures by pushing up producer price inflation. But the longer interest rates must stay high to bring domestic inflationary pressures under control, the deeper the industrial recession. All which explains why the Bundesbank has been so keen for the federal government to bring public spending under control; and why last week's three per cent pay increase for German public sector workers, announced on the same day as German headline interest rates fell, was much the more important economic news for Europe.