The FTSE 100 dropped sharply on news of the rate hike, while sterling gained ground.

The City had been confident that rates would be held at 7.25% after recent surveys suggested a slowdown in both the manufacturing and service sectors due to the strength of the pound.

The Bank of England committee said the central issue was whether demand would slow down quickly enough to lower inflation before the effects of increases in the pound wore off.

"Evidence has emerged over the past month that the cumulative tightening of the labour market has resulted in a rate of private sector earnings growth that jeopardises achievement of the inflation target over the medium run," a statement said.

The UK Treasury said the rate rise reinforced the need for greater pay responsibility.

Borrowers nervous

Housebuyers will be waiting to see if they face higher mortgage bills as a result of the decision which should mean higher rates of return for savers.

Banks and building societies said they were watching the market before making a decision on the cost of borrowing.

A spokesman for Britain's biggest mortgage lender, the Halifax said: "We are very surprised by this decision to raise interest rates again. There will be no immediate announcement in regards to mortgage rates."

A spokesman for the Nationwide building society said: "If we raise mortgage rates then we will ensure that interest rates for savers also go up."

Sixth rise under Labour

Many economists predicted at the end of last year that there would be a need for another rate rise early in 1998 to cool the economy down - the sixth since Labour came to power.

But recently analysts suggested that the economy appeared to be cooling down all by itself. Production industries including manufacturing are technically in recession.

Fears that consumer demand could stoke inflation have also eased, with Tuesday's consumer credit figures for April showing the weakest activity since September 1997 when the death of Diana, Princess of Wales saw borrowing plummet.

High Street sales figures have also been below expectations.

Economists failed to spot move

Analysts' confidence that rates would stay on hold were demonstrated in a poll of City economists for BBC Business Breakfast.

It showed 19 out of 20 believed rates would remain unchanged when the monetary policy committee met.

Sixteen thought rates had peaked, while four expected further rises this year. Three thought rates would reach 7.5% and one forecast 8%.

The Bank of England's committee of eight was split down the middle in February and March and voted five-three vote in favour of a freeze in April.