Euro bank ratchets up rates

The European Central Bank yesterday moved to stamp out the threat of increased inflation in the euro zone with an aggressive half point rise in borrowing costs, ignoring fears that it could choke off Europe's recovery.

Wim Duisenberg, ECB president, said signs of a pickup in price pressures had prompted a rise in rates from 3.75% to 4.25%. He hinted at further rises when he emphasised that monetary policy was still "accommodative".

Market analysts had been braced for a quarter point rise in response to the recovery in growth over the past year, but were surprised when the ECB opted for a tougher stance. They now expect it to take a pause before any further tightening this year.

Paul Bednarczyk, currency strategist at 4Cast, said the half point move "smacked of overkill" when unemployment is only just below 10% and the biggest economy in the zone - Germany - is struggling domestically.

Although the 11-nation euro zone has seen exports boosted by a fall in the single currency on the foreign exchanges over the past 18 months, the ECB is concerned that its weakness threatens its 2% inflation ceiling.

Mr Duisenberg said risks to price stability in the medium term have "clearly continued to increase" in recent months.

When asked whether the ECB saw no risk of choking off economic recovery, Mr Duisenberg said: "The level of interest rates is still such that even after the increase today... it will rather promote growth than stifle it."

The euro jumped half a US cent after the rate announcement but later surrendered all gains sinking to day lows of around $0.955.

"The market was certainly caught on the wrong foot with the move," said Jonathan Bayley at Paribas in Paris.

"I think it's doubtful whether the decision was the best for the euro for several reasons." Markets might have perceived the rise as an effort to prop up the currency.

Yesterday's move by the ECB is the fifth increase in rates since November, when they stood at 2.5%. The combination of low interest rates and a cheap currency strengthened economic prospects in countries in the euro zone, particularly those on the fringes such as Spain, Portugal and Ireland, and in France.

But with inflation in some of the smaller economies threatening to escalate, the ECB has faced a difficult balancing act between promoting growth in the more sluggish regions and capping price pressures. But many analysts suspect concerns about the weakness of the single currency have prompted its aggressive tightening of policy.

Interest rates in the United States are well above those in euroland at 6.5%, and may be pushed higher when the Federal Reserve meets this month.

Following the Bank of England's decision on Wednesday to keep Britain's interest rates on hold, sterling reacted to yesterday's ECB decision by tumbling to a seven month low of 0.6335p to the euro.

"With speeches from Fed officials still on the hawkish side, the Bank of England now seems the only one of the major central banks to be keeping rates on hold, thus giving sterling its negative tone," said Mr Bednarczyk.