Europe raises interest rates

ECB head Wim Duisenberg surprised markets with the large rate move

The European central bank has raised interest rates by a higher-than-expected 0.50% to 4.25%.

The euro briefly hit a ten-week high of $0.97, having gained half a cent to $0.96 in the immediate aftermath of the announcement.

The rise in rates provides a much-needed psychological boost to the currency, which in early May hit a low of $0.88.

Many had expected the bank to raise rates by a quarter of a percentage point. The ECB president Wim Duisenberg said the main impetus for the rate rise was forecasts for higher inflation.

"One of the motives to move by a half a point is that in our view such a move will clear the horizon for some time to come - we don't know how long," he said.

"Most inflation forecasts have been revised upwards over recent months," he said, adding that "the growth outlook has improved markedly in recent months."

Switch to variable rate

The ECB also announced that it was to switch to a variable-rate system of refinancing.

This means that banks not only bid for the volume of funds they want to borrow, but also the rate at which they want to borrow.

The growth outlook has improved markedly in recent months

ECB president Wim Duisenberg

This regime usually leads to higher interest rates, a move as such likely to lend support to the euro.

The size of the rate rise surprised analysts.

The Halifax's Steven Pearson believes it is pre-emptive and could mean lower rates in the long-term.

"I think the ECB has reacted to domestic pressures that will be materialising in the coming quarters. All the data coming from the euro zone has been very strong in the past few weeks...It could also mean that the peak in rates will be lower because of the ECB's pre-emptive move," he said.

Taking lead from US?

The US Federal Reserve raised US interest rates by 0.5% on 16 May, a move which increased pressure on the European Central Bank to raise rates.

US markets were thought to have become immune to smaller interest rate rises, hence the Fed's decision to raise rates by 0.50%.

The same may also be true of European markets.

The ECB has raised interest rates three times this year, in February, March and April.

Even after raising rates, economic growth in the euro zone euro area is still expected to continue to accelerate this year.

Rising cost of oil

The recent rise in oil prices has also reawakened fears that inflation could rise in euro zone countries.

Oil prices have risen to levels not seen since Opec reached an agreement in March to increase production.

"We have very high oil prices again and this poses a slight upward risk to our inflation forecast," said Frank Schroeder of HSBC Trinkaus.