Euro zone interest rates might have to rise more than currently foreseen if upward risks to inflation come to pass, European Central Bank Governing Council member Axel Weber has warned.
The ECB's current thinking is that a further rate increase would be required as growth in the 12-nation region firmed, Mr Weber told the Frankfurt Business Journalists Club.
The ECB held its key rate at 3 per cent last week, and markets and most economists expect it to raise rates twice more this year to 3.5 per cent, then pause.
But Mr Weber signalled an extra 0.5 per cent of monetary tightening might not be enough, although he said he was not suggesting lifting rates to a level where they drag on growth, currently turning in its best performance in six years.
"Recent developments have been positive but the risks in the medium-to-longer term are such that if they were to be realised, further action over and above that envisaged in our main scenario would be warranted," Mr Weber said in response to a question about the prospect of rates hitting 4 per cent in 2007.
"A marked deterioration in the price outlook could call for stronger action. We do not go by the calendar, but depend on economic developments."
The euro strengthened slightly on his comments and bond and interest rate futures lost some ground as markets took on board the prospect of rates rising past 3.5 per cent.
Mr Weber acknowledged growing political unease about a faster pace of ECB rate rises in the second half of the year, compared to the 0.25 percentage points a quarter pace seen before summer.
Many economists believe growth has already peaked and will face headwinds next year as growth in the United States and the global economy eases. But Mr Weber defended upgraded forecasts for growth and inflation by ECB staff, which he said reflected the Governing Council's main scenario and underpinned its rate decisions.
The 12-nation region was expected to expand at around its 2 per cent potential rate in both 2007 and 2008, Mr Weber said, after expected growth of about 2.5 per cent in 2006. The recovery, along with a rise in value-added tax in Germany, increased the risk of high oil prices feeding into wage demands and consumer prices.
"A real interest rate of a half or even one per cent is not consistent with rates close to a neutral level," Mr Weber said. But he signalled the ECB was not planning to cross the barrier into restrictive territory, saying: "I am not talking about pursuing a restrictive course of action."
Asked about the chance of a 0.5 percentage point move, Mr Weber said it would be wrong to rule out any options but observers should not take that as a hint that a bigger move was likely.
In Germany, the region's biggest economy, Mr Weber said the Bundesbank, of which he is President, expected growth of 1-1.5 per cent in 2007, higher than previous forecasts, although a rise in value-added tax would hit the economy in the first quarter.