There were fears yesterday that the Bank of England could raise interest rates 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 reassess the outlook for interest rates on both sides of the Channel. Both the Bank and the ECB held rates yesterday despite worsening economic prospects, spurning pleas for action to buoy growth as they continued their fight to quell rising inflation.

The hardline decision from the Bank came as the clamour for rate cuts was fuelled by news that Britain's housing slump was gathering pace. Figures from Halifax showed that house prices are plunging at twice the rate of the property market's drastic downturn in the early Nineties.

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 far more aggressive stance. A warning from Jean-Claude Trichet, the President of the ECB, that eurozone rates could rise by next month ignited City betting that the Bank of England's next move might also be a rate increase. Markets are pricing in an 80 per cent chance that UK base rates will be increased by December.

Traders and economists said that they were stunned by Mr Trichet's warning. He said that the ECB had debated raising rates yesterday in response to inflation that had “risen significantly since the autumn of last year”. He implied that a potential quarter-point rise in eurozone rates could be expected at its next meeting.

The comments surprised 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 the 80.98p record set in April.

The emerging threat that the Bank may raise base rates this year will cause worries for families that are struggling with the rising cost of living and declining house prices. These sank by a further 2.4 per cent last month, extending losses that have left them down by 6.6 per cent since January, wiping £13,000 off the value of the average home.

House Prices have fallen twice as fast in the past five months as in the same period in 1992, during the most recent property crash, when they fell by only 3.3 per cent, based on Halifax figures. The decline in prices this year is the biggest five-month fall since records began in 1991. If the deterioration in house prices continues at its present pace, the value of a home will slump by more in six months this year than in the whole of 1992, when prices fell by a total of 7.2 per cent. Some economists forecast that prices could fall by up to 12 per cent this year, followed by further declines next year.

The threat that a brutal housing crash could be more severe if the Bank raised rates is certain to sound alarm bells at the Treasury.

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

The grim news came as the Chancellor battled to fend off Conservative attacks over Britain's deepening economic plight. 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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