European Central Bank President Jean-Claude Trichet stepped up his anti-inflation rhetoric on Thursday after the ECB held eurozone interest rates steady at 2 percent in the face of rising oil prices.
But a downgrade to the ECB's growth forecast for this year and next caused bond prices to surge, after markets judged the ECB would be forced to think twice before raising rates.
Trichet said the ECB must be particularly watchful as rocketing oil prices could push up prices more broadly in the 12 countries that use the euro.
"At present, particular vigilance with regard to upside risks to price stability is warranted," Trichet told reporters at his first monetary policy news conference after the ECB's August break.
Rising oil prices place the ECB between a rock and a hard place, analysts said. There is no simple solution to the twin problems of slowing growth and burgeoning inflation, beyond trying to convince markets everything is under control.
"The main message is that the talk is tough but action will be pragmatic," said Jonathan Hoffman, chief European economist for Royal Bank of Scotland Financial Markets.
Prices on European government debt markets soared to contract highs when Trichet announced ECB staff had downgraded their growth forecasts. Yields on 10-year Bunds, which move in the opposite direction to prices, touched a record low of 3.07 percent.
The growth forecast was cut to around 1.8 percent for 2006, compared with a 2.0 percent forecast three months ago. Inflation was revised upwards to about 2.2 percent for 2005 and 1.9 percent in 2006 from 2.0 percent and 1.5 percent respectively in the June forecasts.
Trichet blamed the pressures from crude oil, which has shot up by over 25 percent in the past three months.
"The most recent economic indicators have been supportive to the view that economic growth could improve in the second half of 2005, while higher oil prices continue to weigh on demand and confidence," he said.
Trichet also said the ECB wanted more information on a scandal surrounding the Bank of Italy, which has been accused of favouring Italian banks in take-over battles, and reiterated his support for consolidation in the European banking sector.
Italian Prime Minister Silvio Berlusconi said on Wednesday he would back reform of Italy's central bank after a scandal over its Governor Antonio Fazio's handling of a bank take-over battle, and the issue will be taken up by the Italian government on Friday.
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