Eurozone market interest rates headed higher on Tuesday, in effect tightening monetary policy in the 16-country bloc, as European Central Bank operations drained excess liquidity from the financial system.

The rise in borrowing costs highlighted the balancing act faced by the ECB, which holds an interest-rate setting meeting in Frankfurt on Thursday. A rapid rise in borrowing costs faced by consumers and industry could choke off the economic recovery.

The ECB regular weekly open market operation was closely watched because it was the first since the return last week of €442bn ($557bn, £368bn) in one-year loans, some of which were rolled over into six-day loans that expired on Tuesday. The ECB allotted €229bn of seven-day funds to eurozone banks, nearly €50bn less than the amount of loans maturing.

“This does suggest the strains in the system are easing, but we have to be careful as this is just one tender and these markets are very fragile,” said Don Smith, economist at Icap.

By reducing the amount of excess liquidity in the financial system, the operation put upward pressure on market borrowing costs. Eurozone overnight interest rates rose to 0.424 per cent from 0.405 on Monday.

Separately, the main euribor rates, which measure the cost of interbank lending, hit their highest levels in 10 months.

Although set before the ECB announced the results of its auction, they showed that concerns about the health of Europe’s banks remain significant and continue to put upward pressure on borrowing costs.

The three-month rate, traditionally the main gauge of interbank euro lending and a mix of interest rate expectations and banks’ appetite for lending, climbed to 0.797 per cent from 0.793 per cent on Monday, the highest level since early September.

The ECB will be comforted by signs that market tensions are easing. So far the rise in interest rates has also been steady rather than dramatic – and comes amid signs that the eurozone economic recovery remains on track. “If there is a gradual tightening in the face of an improving economy then the ECB is likely to be able to live with that,” said Julian Callow at Barclays Capital.

No fresh policy initiatives are expected to be announced on Wednesday by the ECB governing council, which hopes publication of “stress test” results for Europe’s largest banks later this month will further boost confidence.

The ECB will also be pleased that it succeeded yesterday in successfully reabsorbing €59bn in liquidity injected as a result of its purchases of eurozone government bonds. Last week, a similar operation failed to withdraw the full amount – apparently because banks were anxious to hold on to liquidity ahead of the return of the €442bn in 12-month liquidity loans.

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