Inflation fears prompt ECB to raise rates to 4.25 per cent

The European Central Bank has increased eurozone interest rates by a quarter percentage point to 4.25 per cent, amid worrying signs that the oil price boom and the credit crunch are getting worse rather than better.

Yesterday's increase, the ECB's first for more than a year, reflects worries across Europe that inflation is rising sharply. Falling growth and rising prices both inside the eurozone and beyond have hit markets hard in recent days, with stocks in London technically entering bear territory at one point yesterday, registering a 20 per cent fall from their peak of last June.

The president of the ECB, Jean-Claude Trichet, warned that he would be alert to the continuing dangers of inflation. "The fact that we have not mentioned heightened alertness nor strong vigilance doesn't mean anything," he said. "We said very clearly last time that it was possible but not certain that we would increase rates today. You see what we have decided unanimously today and we will communicate in a fashion that will be clear and permit the observers, our fellow citizens and markets to see what we will do.

"I never comment myself on future markets; I said already we have no bias, we are not precommitted, we do whatever is necessary to deliver price stability."

Despite the apparent even-handedness of Mr Trichet's remarks, the euro fell against other leading currencies on the expectation that the ECB would not increase rates again soon, though the markets have priced in at least another quarter point rise over the next year.

Inflation in the eurozone hit 4 per cent last month as growth across the single-currency area slowed, while some countries, such as Ireland and Spain, are grappling with a sharp recession in their property markets. However, even these countries did not actively oppose the rate rise, and the vote on the ECB's Governing Council was unanimous. Relatively strong retail sales figures strengthened the case for a rate hike, though the rise was widely anticipated. Most analysts took the view that the Bank of England would not follow the ECB when the Monetary Policy Committee makes its next announcement on rates, on Thursday.

Certainly, the "balancing act", as the Governor, Mervyn King often calls it, faced by the Committee as they face the twin dangers of recession and inflation is not growing any easier. The price of oil reached a new peak during London trading, as Brent crude crested the $146 (73.64) a barrel mark for the first time. Brent crude soared by $2.43 to $146.69 a barrel in London at its high. American prices rose by a similar amount - about $4 this week alone. Oil prices have risen by about 50 per cent since the spring, and have more than doubled over the past year.

Bank of England officials have made clear that the peak of inflation, which will come in the autumn, is vitally dependent on the trends in domestic fuel process, which in turn are driven by ever higher global energy costs.

The Bank has admitted that it is "likely" that inflation will exceed 4 per cent. Nor is the credit crunch is showing any signs of abating. The Bank of England's latest Credit Conditions Survey warned that "lenders had reduced the availability of secured credit to households in the three months to mid-June. Lenders' expectations for house prices were reported to have been a factor contributing to their tightening. They expected a further decline in secured credit availability over the next three months."

The Bank added that default rates were rising: "Lenders anticipated increases in both defaults, and losses on defaults, on secured and unsecured household lending and lending to corporates." The decline in the availability of credit, to companies as well as would-be homebuyers, and spiralling input costs have already pushed the services sector of the economy - 70 per cent of the national income - into a sharp downturn. Financial services have been especially badly hit. According to the Chartered Institute of Purchasing and Supply, activity in the service sector contracted in June at its sharpest rate since the terror attacks of 11 September 2001.

Vicky Redwood, the UK economist at Capital Economics, said: "The economy has already ground completely to a halt. And with credit conditions expected to tighten yet further, there is an increasing chance that the UK falls into outright recession."

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