The Wall Street Journal

FRANKFURT — The European Central Bank raised its key interest rate Thursday by a quarter of a percentage point to 4.25% to tame rising inflation, even as growth across the 15-nation euro-zone shows continuing signs of slowing significantly.

The increase, the central bank’s first interest-rate move in over a year, was flagged by ECB President Jean-Claude Trichet after policy makers’ meeting last month. Analysts will watch Mr. Trichet’s press conference this afternoon closely for signs of whether the bank’s 21-member Governing Council believes more increases are necessary to fend off rising inflation and inflation expectations.

Inflation across the bloc rose to 4% in the year to June, the highest since official records began in January 1997 and double the ECB’s preferred range of just below 2%. Consumer-inflation expectations are at their highest since December 2001, and many market measures of inflation expectations have also risen considerably since last month’s meeting.

Inflation pressures are buffeting central banks globally, even as growth slows. Sweden’s Riksbank raised its key rate to a 12-year high of 4.5% from 4.25% Thursday and said further rate increases are likely this year. Iceland’s central bank, meanwhile, kept its key rate on hold at 15.5%, the highest level in the industrialized world, amid double-digit inflation and an increasingly grim economic outlook.  

Many indicators of the euro zone’s economic health continue to deteriorate. Service-sector activity, which accounts for about three-quarters of the bloc’s economy, contracted by more than expected in June, according to the Purchasing Managers Index released Thursday by research firm Markit Economics.

The service-sector PMI fell to 49.1 in June, below the 50 threshold separating expansion and contraction and down from an earlier estimate of 49.5. In June, Markit reported a combined indicator for both the services and manufacturing sector contracted for the first time in five years, amid high oil prices, a strong currency, and the threat of rising interest rates.  

Euro-zone retail sales rebounded more strongly than expected in May compared to April, statistics agency Eurostat also said Thursday. But economists cautioned the rise is likely temporary and suggested the overall trend is downward, noting the 1.2% monthly rise still left combined sales volumes for May and April below the first-quarter average.  

U.K. economic growth also showed further signs of stalling Thursday, with Britain’s dominant service sector contracting sharply in June, stoking fears the British economy could slip into recession.

The Bank of England has cut its key rate three times since December, but with inflation at 3.3% in May — well above the Bank’s 2% target — policy makers are expected to keep their key rate steady at 5% at their rate-setting meeting on July 10.  

Observers disagree about whether the ECB will follow Thursday’s hike with more.

Since the central bank’s meeting last month, several policy makers have said they do not plan a series of increases. Many economists contend slowing growth will dampen inflation pressures, reducing the need for further increases.

Euro-zone politicians — including in Germany, where politicians typically defer to the central bank’s independence in setting rates — have cautioned monetary policy makers to be mindful of how higher rates could impact growth.

Investors, however, have priced in a second increase to 4.5% by October.  

Economists doubt that one increase will be enough to tame rising inflation. Thursday’s increase, along with any signs the ECB is poised for further action, is likely to boost the euro against the dollar, pushing the common currency — which hovered around $1.588 in European trading — closer to its previous highs above $1.60.

The U.S. Federal Reserve is not expected to raise its key rate from its current 2% until later this year, and higher interest rates can attract investors to a currency. A dollar slide, in turn, could push up the price of oil, which is denominated in dollars.