Fears erupted yesterday that the Bank of England may soon raise interest rates, rather than cutting them, after the European Central Bank issued a surprise warning that surging inflation could force it to lift eurozone rates as early as next month.

The ECB’s abrupt move to a state of high alert over inflation stunned markets and triggered a scramble by the City to rethink interest rate prospects on both sides of the Channel.

Both the Bank and the ECB yesterday held rates despite worsening economic prospects, spurning pleas for action to buoy growth as they kept up their fight to quell rising inflation.

The hardline decision from the Bank to focus on combating inflation came as the clamour for rate cuts was fuelled by news that Britain’s housing slump is gathering pace. House prices are plunging at twice the pace seen during the property market’s drastic early Nineties downturn, Halifax figures showed.

The Bank’s tough verdict was widely expected after its clear signals that inflationary pressures ruled out rate cuts for several months, at least. However, markets were caught off-guard by the ECB’s sudden shift to a much more aggressive stance.

A warning from Jean-Claude Trichet, the ECB President, that eurozone rates could rise by next month ignited City speculation that the Bank of England’s next move might also be a rate increase.

After a surge in inflation in April, City future markets had already begun to bet that rates could rise late this year. But yesterday's ECB inflation alert saw expectations of British rate rises soar.

Markets are now betting on an 80 per cent chance that base rates will be increased by December. Bets on eurozone rates showed the odds on a rise by next month for the leaping to 60 per cent.

Traders and economists said they were stunned by Mr Trichet’s warning. The ECB’s President said that it had debated raising rates yesterday in response to inflation that had “risen significantly since the autumn of last year”.

The Frankfurt-based central bank was now “in a state of heightened alertness”, Mr Trichet said. “We could decide to move our rates a small amount at our next meeting … I don’t say it is certain. I say it is possible.” This implied a potential quarter-point rise in eurozone rates, he added.

The comments rocked bond markets, igniting fears over inflationary dangers. Inflation-sensitive gilt-edged stocks tumbled, sending their yields soaring to seven-month highs.

The pound also fell sharply against the euro as traders bet on a eurozone rate rise. The euro jumped by almost a penny to 79.48p, within striking distance of April’s 80.98p record.

The emerging threat that the Bank may raise base rates this year will spark anguish among households struggling with the rising cost of living, and homeowners watching house prices tumble.

House prices sank by a further 2.4 per cent last month alone, extending losses that have left them down 6.6 per cent since January, wiping £13,000 off the average home’s value.

Prices have fallen twice as fast in the past five months than during the same period in 1992, during the last property crash, when they fell by only 3.3 per cent, based on Halifax figures. The decline in prices so far this year is the biggest five-month fall since 1991.

The grim threat of a brutal housing crash that would grow still more severe if the Bank now raises rates is certain to sound alarm bells at the Treasury.

Bradford & Bingley will pile on the pain today when the troubled lender lifts rates on all of its home loan products, although it has not yet said by how much.

The Chancellor battled to fend off Conservative attacks over Britain’s deepening economic plight yesterday as the Bank’s decision to peg rates and the new fall in house prices piled pressure on the Government.

Alistair Darling was thrown on the defensive as George Osborne, the Shadow Chancellor, accused the Government of acting like a “rabbit in the headlights”. The Chancellor insisted, however, that the economy was “strong and resilient”.

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