June 23 (Bloomberg) -- Europe's manufacturing and services industries unexpectedly shrank and German business confidence slumped in June, increasing concern the European Central Bank's plan to raise interest rates next month will hurt growth.

Royal Bank of Scotland Group Plc's composite index fell to 49.5 from May's 51.1, the first time it's dropped below 50, the dividing line between expansion and contraction, in five years. The Munich-based Ifo institute said its business climate index, based on a survey of 7,000 executives, declined to 101.3 from 103.5. That's the lowest since January 2006.

``The ECB is taking a great risk with the economy by raising rates,'' said Holger Schmieding, chief European economist at Bank of America Corp. in London. ``The data clearly show that a sharp economic downturn is in the pipeline and the bank may end up getting the blame for it.''

The ECB has said it may raise its benchmark rate by a quarter percent next month to 4.25 percent to contain inflation. Policy makers are split on whether one step will be enough to keep a lid on prices, which last month increased at the fastest pace in 16 years after oil and food prices rose to a record.

``Today's data is not enough to deter the ECB from raising rates in July,'' said Juergen Michels, an economist at Citigroup Inc. in London. ``However, it strengthens the hands of the council members more concerned about growth.''

Investor Bets

The euro fell as investors pushed back expectations for a second interest-rate increase to December from October. The single currency dropped the most in a week and traded at $1.5515 at 2:15 p.m. Frankfurt time. The majority of investors still forecast inflation concerns will force the bank to lift borrowing costs for a third time in March, Eonia forward contracts showed.

ECB executive board member Lorenzo Bini Smaghi said last week one step should be ``enough'' to bring inflation back to the ECB's goal of just below 2 percent and that rising oil prices will leave their ``mark in the second half of the year.''

By contrast, his fellow board member, Juergen Stark, said he expects a ``gradual recovery as soon as the second half of the year.'' Cypriot council member Athanasios Orphanides said he ``cannot rule out'' that further interest-rate increases may be necessary after July.

Policy makers say the region's economic fundamentals are sound and inflation remains their main concern. The euro-area economy will expand about 1.8 percent this year and 1.5 percent in 2009, according ECB forecasts. Prices rose 3.7 percent from a year earlier last month. The ECB forecasts that inflation will average 3.4 percent this year and 2.4 percent in 2009.

Oil-Price Increase

The price of oil has doubled over the past year to a record $139.89 a barrel on June 16, boosting companies' costs and eroding consumer's purchasing power.

Volkswagen AG, Europe's largest automaker, said sales of VW-brand cars declined last month as higher fuel prices discouraged buyers. Air Berlin Plc, Europe's third-biggest low- cost airline, said last week it will cut its fleet and drop flights to Beijing and Shanghai to make up for rising prices.

``The high oil price has all the characteristics of a shock,'' said Gerd Hassel, an economist at BHF Bank in Frankfurt. ``Companies are right to expect harder times.''

Adding to pressure on companies is the euro's 15 percent increase against the dollar in the past 12 months, which makes exports less competitive outside the currency region.

Heidelberger Druckmaschinen AG, the world's largest printing press maker, on June 10 forecast a ``significant'' drop in annual profit, citing slowing demand and the stronger euro.

Raising Prices

Some companies are coping with the economic decline, helped by expansion in Asia and Eastern Europe and by raising prices.

MAN AG, Europe's third-largest truckmaker, on June 4 stuck with its full-year targets, saying growth in Poland and Russia is offsetting slowing economies elsewhere. BASF SE, the world's biggest chemicals maker, also maintained its full-year profit forecast this month as it expands in Asia. The company last week said it will increase prices by as much as 20 percent because of higher raw-material, energy and freight costs.

The PMI's price index makes ``painful reading,'' said Kenneth Wattret, chief euro-area economist at BNP Paribas in London. An index of input costs jumped 3 points to 67.4 in the month, the highest since October 2008, while the reading for output prices rose to 55.6 from 54.8.

ECB President Jean-Claude Trichet said June 5 that the bank is ``monitoring wage negotiations and price-setting behavior in the euro area with particular attention.''

``The ECB has turned its back on growth as inflation concerns dominate,'' said Jacques Cailloux, Royal Bank of Scotland Plc's chief euro-area economist.

To contact the reporter on this story: Gabi Thesing in Frankfurt gthesing@bloomberg.net

Last Updated: June 23, 2008 08:32 EDT