The euro recovers strongly on foreign exchange markets after the European Central Bank boosted interest rates.

The currency was also boosted by the news of a huge merger between the UK's Vodafone and Germany's Mannesmann, which has convinced US investors that Europe may yet embrace economic reform.

By 1030GMT, the euro was trading at 0.99 to the dollar, just under parity and much stronger than in recent days.

"A complete shift in mood has engulfed the euro, and investors can now see that there are real changes in corporate Europe. This will be of particular interest to U.S. investors who had previously viewed Europe as over-regulated and lacking in dynamism," said Nick Parsons, currency analyst at Commerzbank.

The dollar has also been weakened by fears that strong US growth may force the Fed, the US central bank, to raise interest rates even further.

ECB takes action

On Thursday, the European Central Bank put up interest rates by 0.25% to 3.25%.

The move, which surprised many analysts, came after the euro tumbled in January.

The ailing currency has fallen 17% against the dollar since its launch at the beginning of last year.

ECB president Wim Duisenberg has repeatedly expressed confidence in the euro's fundamental strength.

But earlier this week he said a continuous weakening could pose a risk to price stability.

That could lead to eurozone inflation going through its 2% ceiling.

The decision to put rates up was made at a closed-door meeting of the ECB's governing board, the officials who set monetary policy for the 11 countries using Europe's common currency. The increase will take effect from 9 February.

It came earlier than many analysts had expected - normally the markets were prepared in advance, said one.

But Mr Duisenberg argued that his earlier comments had paved the way for the rise.

Inflation risk

He said the risk of inflation due to rising oil prices and the growth in the amount of money in circulation both contributed to the decision.

But he emphasised that the root cause of European inflation was not a weak local economy, but a strong US economy.

He agreed that the weakness in the euro had played a role, but said it had not been the overwhelming factor.

"Inflation rates are now approaching higher levels than expected earlier, and larger and more protracted commodity and producer price increases are heightening the risk of second round effects," said Mr Duisenberg.

"Against this background it is crucial for wage negotiators to be able to rely on the maintenance of price stability in the medium term."

Investment returns boosted

But some observers fear that the rise could depress the eurozone economy just as it is beginning to pick up.

Raising interest rates tends to buoy the local currency by boosting returns on investments in bonds denominated in euros.

But it also cools off an overheated economy by making it more expensive to borrow money.

This is the second time the ECB has raised rates in its short history - in November they went up by half a point.

There had been speculation that the ECB might hold off for the moment because the US Federal Reserve, which is also worried about inflation, raised short-term interest rates on Wednesday.

The Fed added a quarter-point to its lending rate, taking it to 5.75%.