RISING OIL prices are likely to buoy inflation and prompt the European Central Bank (ECB) to tighten interest rates, according to Bank of Ireland's June Bulletin.

Food and fuel prices have risen sharply over the last 12 months - by 6.4 per cent and 13.7 per cent respectively - and together they have pushed the euro zone annual inflation rate to 3.7 per cent.

Dan McLaughlin, chief economist with Bank of Ireland, said the inflation acceleration was likely to result in the ECB raising rates by 0.25 per cent next month, "contrary to our and most of the market's expectation that the next move would be down". He said markets have now priced in the expectation of a half-point rise in rates by the end of the year.

"Higher rates will not affect inflation in the short term, but the rationale is that it will help to anchor inflation expectations and convince firms and households that the ECB will do all it can to bring inflation back to the target", Mr McLaughlin said. Consumers' expectations of inflation probably owed more to high-frequency purchases such as food and energy than central bank policy.

"The near-term path of oil prices will prove decisive in determining headline inflation expectations and hence ECB policy," he said. "A further acceleration in oil prices and further spike in headline inflation may mean even tighter policy, however, even though the resultant slowdown would be such that the ECB would probably end up cutting rates aggressively in 2009." He said the euro may end the year at about $1.50 instead of the $1.40 forecast.