Borrowing costs are set to rise after the European Central Bank increased interest rates for the euro zone yesterday by one-quarter of a percentage point to 3.25 per cent.

The bank's president, Mr Wim Duisenberg, denied that the move was a panic response to the euro's recent battering on the financial markets but he acknowledged that the exchange rate had been a factor in the governing council's decision to raise rates.

"Developments in the exchange rate of the euro are becoming a cause for concern with regard to future price stability. At the end of January the nominal effective exchange rate of the euro stood approximately 11.5 per cent below its level in the first quarter of 1999. "Given both the magnitude and the duration of this development, import prices can be expected to rise further, thereby increasing the risk that upward pressure on consumer price inflation might materialise in the medium term," he said.

In the immediate aftermath of the decision there was further selling of the euro. But within a few hours it began to turn as analysts pointed to the benefits of the rate hike.

The euro closed at $0.9886 from $0.9750 and at 61.65p against sterling from 60.69p. As a result the pound closed at 78.27p against sterling from 77.06p.

Traders said one positive factor for the euro was the prospective friendly merger of German telecoms and engineering group Mannesmann with Vodafone AirTouch.

Analysts said the €174 billion (£137 billion) deal would eclipse the entire deficit in foreign direct investment suffered by the euro zone last year.

They emphasised the actual direct foreign exchange flow would not be anything as great as the nominal bid value, as it was an all-share offer. But the sheer size of the deal suggested Vodafone would need to purchase euros at some stage.

Speaking in Frankfurt after the fortnightly meeting of the governing council, which includes central bankers from all 11 euro zone member-states, Mr Duisenberg said that everyone at the meeting agreed that rates should rise. But there was some disagreement over how large the increase should be and when it should take place.

Until last week, few analysts expected the ECB to increase rates before March and most expected that the next increase would, like the previous two, be of half a percentage point. Mr Duisenberg said that, apart from the exchange rate, monetary and credit growth and increases in commodity prices threatened to push inflation in the euro zone above the ECB's self-imposed limit of 2 per cent.