Rates and eyebrows raised in Europe

For the European Central Bank, dedicated to slaying the dragon of inflation, the moment of truth arrived on Thursday. The bank raised its benchmark interest rate a quarter of a percentage point to 4.25%, making good on a promise last month that it would act to curb food and fuel prices.

But with Europe's economy slowing, the bank stopped well short of signalling the start of a new round of rate increases, as many bank watchers had expected. "Starting from here, I have no bias," the bank's president Jean-Claude Trichet declared at a news conference.

Trichet's measured words soothed markets, helped halt a slide in the dollar against the euro, and may have mollified European leaders worrying that higher exchange rates could choke their weakening economy.

The bank's decision to tighten credit has been watched, and debated, as much as any in its 10-year history because it comes just as economic growth appears to be deteriorating in Europe. It also widens the gulf in monetary policy between Europe and the US, where the number of jobs dropped for the sixth straight month in June.

The Federal Reserve, with interest rates half those in Europe, has so far not raised them, though it has indicated that inflation is a growing concern. Other central banks, from Scandinavia to Southeast Asia, lifted rates this week to combat a global wave of inflation.

"The ECB is the only major central bank that is joining the smaller central banks in raising rates," said Thomas Mayer, the chief European economist at Deutsche Bank in London. "The others are talking tough but the ECB is the only one that is putting action to words."

This has put the bank in an awkward position. Politicians in France and Germany urged it not to raise rates at such a fragile moment. Even within the bank's 21-member governing council, there was a raging debate about whether to act now or hold off, to avoid jeopardising growth.

The latest statistics, which showed inflation in Europe spiking to 4% in June – twice the upper limit set by the bank – seems to have settled the debate for the moment, according to economists. Trichet said the vote to raise rates a quarter point was unanimous.

Underlining the argument that the move was more of a one-time gesture than the beginning of a trend, he repeated a warning to unions not to use inflation as a pretext to demand steep wage increases. The bank frets as much about so-called second-round effects as it does about inflation itself, according to economists.

"They've really gotten everyone's attention," said Holger Schmieding, chief European economist at Bank of America. "Trade unions, governments and others know the bank is dead serious."

Politicians were muted about the rate increase after days of noisy public pressure on the bank from French president Nicolas Sarkozy, the German finance minister Peer Steinbrück and other leaders.

But unions reacted sourly, disputing that inflation could start a wage-price spiral. "The ECB should realise we are no longer living in the Seventies," the European Trade Union Federation said in a statement.

While Trichet reiterated that the central bank's overriding mandate was to manage expectations about inflation, he also acknowledged that the economic picture in Europe was worsening. Manufacturing activity in the 15 countries that use the euro shrank in June for the first time in three years, according to a survey of European purchasing managers. In Spain and Ireland, where a collapse in housing prices has magnified the problems, there is real risk of a recession.

Europe's growth this year, Trichet conceded, would "not be at all flattering," though he disputed suggestions that it faces stagflation similar to that which occurred after the oil shock of the Seventies.

With Europe likely to slow further in coming months, however, economists said that the inflation hawks on the bank's governing council – led by Axel Weber, the president of Germany's Bundesbank – would find it difficult to round up votes for more than one additional rate increase this year.

"We still think there is a need for a further hike," said Elga Bartsch, senior European economist at Morgan Stanley in London. "But given what I heard today, there won't be any rush to do it."

On a day when oil prices surged to a record above $145 a barrel, Trichet devoted a lot of attention to energy markets. He said European consumers needed to accept the reality of higher fuel prices, but he also issued a warning to the Organisation of the Petroleum Exporting Countries not to hoard supplies.

"If we have a supplier-driven artificial scarcity then it is very grave," Trichet said. "To the extent that part of the present prices are coming from a cartel, this is very, very abnormal."

Wading into a subject that is politically contentious in the United States, Trichet also urged industrialised countries not to hinder drilling and other types of exploration for oil. He declined to name the countries he had in mind, saying this was an issue in several of them.

The Bush administration has pushed for offshore drilling, as has the presumptive Republican presidential nominee, Senator John McCain. Trichet met on Tuesday with the Treasury secretary, Henry M Paulson Jr, prompting speculation that the issue might have come up in that session.

Trichet dwelled on oil in part because it allowed him to make a historical point about the need to fight inflation.

Europe's failure to respond more quickly to the spiralling prices that followed the first oil shock of 1973, he said, sapped the Continent of its economic vitality and ability to create jobs for years afterward.