June 23 (Bloomberg) -- German business confidence fell to the lowest in more than two years in June as record oil prices and the prospect of higher interest rates dimmed the outlook for growth in Europe's largest economy.

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 in May. That's the lowest since January 2006. Economists expected a drop to 102.5, according to the median of 42 forecasts in a Bloomberg News survey.

Germany's Finance Ministry said June 20 growth will slow ``markedly'' in the second quarter after the economy expanded at the fastest pace in 12 years in the first. Rising prices are eroding spending power just as a stronger euro hurts exports. Europe's manufacturing and services industries unexpectedly contracted in June, an industry report showed today.

``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.''

The euro fell after today's reports, to $1.5506 from $1.5566. The price of oil has doubled over the past year to a record $139.89 a barrel on June 16.

The European Central Bank has said it may raise borrowing costs next month to contain inflation even as the economy cools.

Ifo's gauge of the current situation dropped to 108.3 from 110.1 while a measure of expectations fell to 94.7 from 97.2.

Inflation `Challenge'

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.

Inflation in the 15-nation euro area accelerated to a 16- year high of 3.7 percent last month. In Germany, which accounts for about one third of the region's economy, annual price gains reached 3.1 percent. The ECB aims to keep inflation just below 2 percent.

``While the Ifo has remained at a fairly solid level, executives know inflation is becoming one of their main challenges,'' said Stefan Bielmeier, an economist at Deutsche Bank AG in Frankfurt. ``Higher inflation rates will put a brake on global growth, damping demand for German exports further.''

The euro's appreciation against the dollar and the pound has made exports less competitive outside the single-currency bloc. German factory orders and industrial production declined in April.

Economy `Could Contract'

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.

Companies also have to grapple with higher credit costs after the U.S. housing slump made banks reluctant to lend.

``Economic growth in the second quarter could contract,'' said Rainer Guntermann, an economist at Dresdner Kleinwort in Frankfurt. ``Orders will probably continue to decline, but seen over the year it's not the end of the world. Germany will still outperform the rest of the euro area.''

Germany enjoyed an export boom over the last two years, prompting companies to increase investment. That continued in the first quarter of 2008, driving economic growth of 1.5 percent from the previous three-month period.

While growth is likely to be ``more subdued'' in the second and third quarters, it should pick up again at the end of the year, the Bundesbank said June 6. It expects the economy to expand about 2.25 percent this year and 1.5 percent next year after 2.5 percent growth in 2007.

ECB Rates

The euro-area economy will expand about 1.8 percent this year and 1.5 percent in 2009, according ECB forecasts. Policy makers say the region's economic fundamentals are sound and inflation remains their main concern.

Some companies are passing on higher costs. BASF SE, the world's biggest chemical maker, last week said it will increase prices by as much as 20 percent because of higher raw-material, energy and freight costs.

ECB President Jean-Claude Trichet said June 5 the bank may raise its benchmark lending rate by a quarter-point to 4.25 percent next month. The central bank is ``monitoring wage negotiations and price-setting behavior in the euro area with particular attention,'' he said.

``One cannot rule out'' that further rate increases beyond July ``may be necessary,'' ECB council member Athanasios Orphanides said June 11.

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

Last Updated: June 23, 2008 04:30 EDT