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ECB raises rates to 4.25%

The European Central Bank raised interest rates for the first time in more than a year, in a widely expected quarter percentage-point move which took benchmark rates to 4.25%, the highest level since September 2001.

The ECB acted after euro zone inflation accelerated to 4.0% year-on-year last month, more than double the bank's medium-term goal.

“This move is largely a symbolic gesture aimed at getting inflation expectations down,” said Dario Perkins, European economist at ABN Amro.

“I get the feeling that markets are starting to question the inflation credibility of the (US) Federal Reserve and the Bank of England. The signal the ECB are sending today is that they are serious about their anti-inflation mandate,” he added.

Markets were little changed after the decision. Economists are keen to know if this marks the start of a campaign of rate rises, despite growing signs of a slowdown in the euro zone economy.

Several ECB policymakers have said they do not plan a series of increases and most economists see little further scope for tightening as the growth outlook deteriorates. But markets are betting on rates hitting 4.5% by the year-end, and some traders had even seen a chance of a half percentage point move on Thursday.

“It's a bit of a tightrope at the moment,” said Dresdner Kleinwort economist Rainer Guntermann. “In the current uncertain environment, with growth and inflation risks both clearly evident, I would be surprised if there is any guidance given beyond August, but from that point of view they will leave their options open.”

In the lead-up to the decision, economic data has taken a turn for the worse and German Finance Minister Peer Steinbrueck has joined politicians from France and Spain in urging the ECB to have a care for growth.

European Union Monetary Affairs Commissioner Joaquin Almunia said that stagflation, a combination of low growth and high inflation, was an obvious risk to the European economy -- and one which would complicate ECB policy.

Updated purchasing managers' figures released on Thursday showed the euro zone services sector shrank faster than previously thought in June, in line with a fall in manufacturing activity in a similar survey.

Business and consumer confidence continues to weaken, although May retail sales data was better than expected, and money market tensions remain and European shares hit a three-year low on Thursday.

But inflation in the 15-nation region accelerated to a new high in June, oil prices hit a new record above $145 per barrel on Thursday and rising inflation expectations underline the ECB's fear of a damaging wage-price spiral.

Consumer inflation expectations are at their highest since December 2001, just before the introduction of euro notes and coins, and index-linked bond yields are also up.

All but four of 81 economists in a Reuters poll expected a rate rise on Thursday. Forty percent saw the ECB returning rates to the current 4.0% or lower by the first quarter of next year, and just 20% agree with financial markets' expectations for another hike by December.

“It depends on inflation developments,” Perkins said. “Growth data has been pretty dreadful so I think they have to be pretty serious about inflation to raise rates in this environment - you'd have to be brave to predict they won't follow through on their mandate.”

Sweden's central bank raised interest rates by 25 basis points to 4.5% on Thursday, the second rise this year to tackle inflation in an economy which has been relatively little affected by global credit turmoil.

The ECB's description of its stance as one of “heightened alertness” is likely to be dropped or modified in its latest policy statement, and the ECB will probably reintroduce references to uncertainty about growth which it dropped in June.

Some Governing Council members were unconvinced of the need for tighter policy at the June meeting, so they would be reluctant to encourage market expectations of further action, analysts said.

“I would expect a lot of things they said last month to be a bit of a one-off,” said Bank of America economist Gilles Moec. “We expect them to drop 'heightened', keep 'alert', and stress the high uncertainty. That would be a nice way out for them.”

The ECB will also be aware of the potential for further hikes to push the euro up further against the dollar, as the Federal Reserve is not expected to raise US interest rates until late in the year, making higher-yielding euro zone investments more attractive. (Reuters)