The European Central Bank's dilemma over interest rates deepened yesterday as new figures pointed to a “toxic cocktail” of stagnant growth and spiralling inflation.

Jean-Claude Trichet, the President of the ECB, hinted this month that borrowing costs would rise to control inflation, which has soared to a record 3.7 per cent.

However, there was growing speculation that the ECB may keep rates at 4 per cent at its next rate meeting on July 3 after European manufacturing and service companies reported declining activity for the first time in five years and corporate sentiment in Germany plunged.

The RBS/Markit Eurozone Purchasing Managers Index (PMI) for both the manufacturing and service sectors fell to a five-year low of 49.5 in June, down from 51.1 in May. Any figure below 50 indicates contraction.

This is the weakest level since June 2003, when the eurozone economy was stagnating.

Howard Archer, of Global Insight, the economics consultancy, said: “The surveys show a toxic cocktail of essentially stagnant economic activity but elevated and still-rising inflation. This heightens concern about the current state of the eurozone economy and its prospects.”

The PMI for service companies, which range from hotels to banks, fell from 50.6 in May to 49.5, marking the first month that the sector has failed to grow since June 2000.

The manufacturing sector also fell to 49.1 from 50.6 in May, the lowest level since May 2005.

Input prices for manufacturers rose at the fastest pace in 23 months, forcing more firms to raise their prices. Output price inflation hit a 17-month high.

However, declining consumer demand prevented firms from passing on the full increases in their costs, causing their margins to be squeezed more tightly than at any time since November 2004.

As businesses struggled, confidence among German firms fell sharply. The business climate index for Germany, one of the strongest performing countries in the eurozone, slipped from 103.5 in May to a lower than expected reading of 101.3 in June, according to the Munich-based Ifo economic research institute. These gloomy figures caused the euro to slide to about $1.5492 from $1.5611 late last week.

Economists had forecast a more modest fall in the Ifo index to 102.3, prompting Gernot Nerb, an economist for the Ifo institute, to call on the ECB to hold off raising interest rates.

The Belgian business confidence index also fell back sharply to -5.9 in June, down from -1.6 in May. The index hit a three-year low of -7.9 in April.

Jacques Cailloux, an RBS economist, said that a rise to the interest rate could cause a further slowdown in the eurozone. “By lifting rates in July, the ECB will take unprecedented risks with growth in the region,” he said.

However, Jennifer McKeown, European economist for Capital Economics, the consultancy, said that the ECB was unlikely to change its mind about a rate rise. She said: “Inflationary pressures and a solid outlook for the German economy will keep the ECB in hawkish mode for some months yet.”

But she said that the 15 member countries of the eurozone may see interest rates fall next year. “The continued evidence of a slowdown in eurozone activity should prompt significant rate cuts next year.”

Matters of influence

Jean-Claude Trichet, President of the European Central Bank (ECB), is less circumspect than Mervyn King about spelling out future movements in interest rates. When the ECB was formed, it was criticised for not being open enough about its decisions, and some analysts say that this has created an environment where the bank is expected to flag rate moves up to three months in advance. This has not always endeared Mr Trichet to member countries. This month he came under fire from Spain for signalling that rates would rise next month, weeks before the rate-setting committee holds its meeting.

Some observers have even compiled a guide to what Mr Trichet's statements mean. If he promises that the ECB will “continue to monitor very closely” all developments, this usually means interest rates will rise in two months' time. However, giving warning that “strong vigilance remains of the essence” usually indicates that a rate rise is on the cards the following month. Last month Mr Trichet talked for the first time of a “state of heightened alertness”. What this means will become clear at the next rate meeting on July 3.

Ben Bernanke is also concerned with rising inflation but the Fed's mandate differs from its European counterpart, demanding that the central bank also encourage economic growth. This, coupled with Mr Bernanke's fondness for aggressive moves, enabled the Fed to cut rates swiftly after the US sub-prime crisis came to light. It does not have an inflation target but there are increasingly hawkish signals coming from the Fed.

Mervyn King, Governor of the Bank of England, has been sending out mixed messages recently. In his letter to the Chancellor last week, written to explain why inflation had risen by more than 1 per cent above the 2 per cent inflation target, he indicated that the Bank may sit on its hands as inflation rose further, reasoning that trying to control the current surge in prices would result in too much volatility. But only days later he was promising that the Bank would do whatever was necessary to get inflation, forecast to rise to more than 4 per cent this year, back within the target. The minutes from the monetary policy committee's meeting this month suggest that some members may consider voting for a rise next month, prompting a three-way split in the nine-member committee. Markets are not pricing in a rate rise until August, followed by another by November.

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