The European Central Bank (ECB) raised interest rates by 25bps on Thursday, bringing the eurozone's main borrowing rate to a three-year high of 2.5%.

The rate hike was taken amidst growing fears of inflation, given the current economic background of a strengthening eurozone economy and the presence of conditions for ongoing economic expansion.

The quarter-point rise from 2.25% is the second in four months after the bank increased rates from 2% to 2.25% in December.  Before this, rates had been held steady at 2% for more than two years.

Last month, ECB President Jean-Claude Trichet said the bank would remain "vigilant" on inflationary pressure and that whilst economic activity in the eurozone was improving, the ECB needed to ensure this growth did not affect price stability.

The risks of a property bubble and rising debt

Some members of the ECB's 18-strong governing council have also expressed concerns that low interest rates could lead to an unsustainable property "bubble".  Eurozone property prices rose 7.7 per cent in the first half of 2005, causing Mr. Trichet to argue that tighter monetary policy may be required to contain this threat.

On the flip side, increasing money supply and rising debt could also provoke deflationary pressures in the medium term.  Data released this week showed lending to households rose at an annual rate of 9.4 per cent in January, the fastest pace since 2000, with lending to businesses also accelerating.

Uncertain economic outlook

The eurozone's economic outlook for 2006 is mixed.  With protracted relatively high levels of unemployment in the key economies of Germany, France and Spain, GDP growth in the eurozone is currently sluggish averaging 0.3 per cent in the final quarter of 2005.  And in terms of inflation, persistently high oil prices are seen as a major threat.

But in its latest forecast, the ECB predicted higher rates of economic growth - 1.9% across the eurozone bloc in 2006 compared with 1.4% last year.  There are also reports indicating that business and consumer confidence is on the up in France and Germany which are now expected to recover to some extent in the current quarter.

But many are still worried that raising rates prematurely could hamper Europe's economic recovery just as it is gathering momentum.

Most economists anticipate that eurozone rates will rise to 2.75 or 3 per cent by the end of 2006 as pipeline inflation pressures continue.