The European Central Bank's (ECB) dilemma over interest rates deepened today as falling activity in the manufacturing and services sector pointed to a sharp slowdown in the Eurozone.

Jean Claude Trichet, president at the ECB, hinted earlier this month that borrowing costs would rise to control inflation, which has soared to a record 3.7 per cent.

However, the ECB may have to keep rates at 4 per cent after European manufacturing and service companies reported declining activity in June while corporate sentiment in Germany plunged.

The RBS/Markit Eurozone Purchasing Managers Index for service companies fell from 50.6 in May to 49.5 in June.

Any figure below 50 indicates contraction, and it is the first time the sector has failed to grow since June 2000.

The manufacturing sector also declined below 50 to 49.1 from 50.6 in May, the lowest level since May 2005.

The output indices for both sectors declined from 51.1 to 49.5, its weakest level since June 2003 when the eurozone economy was stagnating.

The business climate index for Germany, one of the strongest performing countries in the Eurozone, slipped from 103.5 in May to a lower than expected reading of 101.3 in June, according to the Munich-based Ifo economic research institute.

Economists had forecast a fall to 102.3, prompting Gernot Nerb, an economist at the Ifo institute to call on the ECB to hold off raising interest rates.

Jacques Cailloux, economist at RBS, warned that a rise to the interest rate could cause a further slowdown. "By lifting rates in July, the ECB will take unprecedented risks with growth in the region."

However, Jennifer McKeown, european economist at Capital Economics, the economic consultancy, said that the ECB was unlikely to change its hawkish stance.

"Inflationary pressures and a solid outlook for the German economy will keep the ECB in hawkish mode for some months yet. But continued evidence of a slowdown in euro-zone activity should prompt significant rate cuts next year."

The ECB will make its next rate decision on July 3.

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