Germany's Bundesbank has warned that the decision by EU Finance Ministers to allow Italy to relax its budgetary policy could damage the euro's credibility. Italy's temporary release from the strictures of the stability pact and the euro's continuing weakness are expected to dominate today's meeting of the Governing Council of the European Central Bank in Frankfurt.

The EU Finance Ministers agreed last week that poor economic growth would make it impossible for Italy to keep its budget deficit below the 2 per cent laid down in the stability pact. Although they urged Italy to make every effort to keep the deficit low, the ministers approved an emergency expansion of the limit to 2.4 per cent.

Most analysts blame the decision for the most recent fall in the euro's value.

Mr Edgar Meister, a member of the Bundesbank's directorate, described the ministers' decision as "a stab in the back" for the ECB's monetary policy and insisted that Italy's case must remain an exception in Europe.

He warned that, unless investor confidence in the euro was strengthened interest rates could rise.

Mr Meister's comments follow similar observations by the Bundesbank's president-designate, Mr Ernst Welteke, and the ECB's chief economist, Prof Ottmar Issing. Mr Welteke warned that Europe's politicians could not afford to relax their budgetary policy.

"There are certain trends within Europe which mean that budgetary discipline is no longer taken so seriously," he said. oder for euro weakness, arguing that his failure to introduce necessary reforms has prevented Europe's biggest economy from recovering. On the markets the euro weakened initially yesterday and later clawed back some territory due to weakness in US asset markets. The euro closed at $1.0456 from $1.0434 a day earlier and at 64.99p against sterling from 65.11p. As a result the pound is trading at 82.52p against sterling from 82.67p.

Strong economic data from the US undermined both equity and bond markets and as result the dollar also fell. "Asset markets are the key driver for the dollar at the moment," Mr Jim Power, chief economist at Bank of Ireland said.

The markets are now concerned that the Federal Reserve will act on its "tightening bias" and raise interest rates when it meets on June 30th.

Sterling was bolstered yesterday by the news that manufacturing is now declining less slowly which in turn is underpinning sentiment that UK rates will rise again next year.