When Europe's central bankers gather in Frankfurt next week for the first time since the summer break, they will enjoy a brighter economic outlook than at any time since the launch of the euro. Figures released yesterday by the Munich-based Ifo institute show that business confidence in western Germany rose in line with expectations in July, confirming the view that economic growth in Europe's biggest economy will accelerate in the second half of 1999.

The euro has recovered much of the value it lost against the dollar during the first few months of this year, a development that will reassure the governing council of the European Central Bank (ECB) that the new currency is winning greater acceptance on the money markets.

"It is especially noteworthy that business expectations have risen considerably, which gives us hope for the future economic development in Germany," said Ms Manuela Preuschel, economist at Deutsche Bank in Frankfurt, responding to yesterday's survey.

But central bankers find business optimism almost as unnerving as economic gloom and they have been quick to spot the cloud lurking behind the silver gleam of Europe's economic recovery.

As the spectre of deflation recedes, economic confidence shows signs of disturbing the sleeping giant of inflation, a danger the ECB is constitutionally obliged to avert. If prices continue to rise, the ECB will almost certainly increase interest rates - a move the bank's president, Mr Wim Duisenberg hinted at last June.

US interest rates are expected to rise by a quarter of one percentage point on Tuesday and the financial markets in London, Frankfurt and Paris are feeling nervous. Long-term interest rates have already started to rise, with 10-year German federal bonds offering an annual return of almost 5 per cent compared with just 3.7 per cent at the beginning of the year.

Rising prosperity, the doubling of the price of oil since January and an upward trend in wage costs are all pushing prices up. German economists now predict that inflation could reach 2 per cent next year, forcing a hike in interest rates.

A growing band of analysts predicts the ECB will not wait until 2000 but will increase interest rates before the end of this year. Deutsche Bank Research expects that, by the end of 2000, euro zone interest rates will have risen by one percentage point.

Despite the recent recovery in the value of the euro, Europe's financial markets remain uncertain about the currency's future, not least because of the profound lack of transparency in the ECB's decision-making process. Whereas the chairman of the US Federal Reserve, Mr Alan Greenspan, gives the markets a clear indication of where interest rates are moving, Europe's central bankers formulate monetary policy behind closed doors and offer confusing explanations for their actions.

"The markets don't know which economic factors the ECB are really looking at when they make their decisions," complains Mr Stefan Bergheim of Merrill Lynch.

When the bank surprised the markets in April with an interest rate cut of half of a percentage point, its officials offered a variety of explanations including slow economic growth, a lack of business confidence and the expectation of low inflation.

"If the central bankers take seriously their own arguments from that time, they must now put interest rates back up again," according to Mr Stefan Schneider, chief euro area economist at Paribas.

But the ECB is unlikely to take its own arguments so seriously that it will risk the political opprobrium that would follow an early hike in interest rates. Apart from anything else, such a move would suggest that the reduction in April was a mistake.

Some analysts believe the ECB may seek an ingenious way out of its dilemma by changing the way it lends money to commercial banks. Instead of setting a fixed interest rate for such transactions, the ECB would ask banks to bid for money, a step that would almost certainly make borrowing more expensive but would deflect some political flak from the central bankers.