South Korea's economy is set to grow at 5% this year

The Bank of Korea raised its benchmark rate by a quarter point to 4% - its highest level since May 2003 - after rises in October and December.

The economy is set to grow at about 5% this year and both consumer and business spending have picked up.

The rise came despite fears that high oil prices and the strong value of the won could hit Korea's economic growth.

The country's currency has risen by 4% this year and remains at a near eight-year high against the dollar, putting pressure on South Korean exports.

Interest rates in Asia's fourth-largest economy have now risen from record lows in 2004, when the bank cut borrowing costs as consumers struggled with massive credit card debts.

Growing confidence

The central bank has forecast that core inflation, which excludes food and energy, will rise to 3.3% in the second half of 2006 from 2.1% in the first half, moving towards the top of its target range of 2.5-3.5%.

"The economy is recovering faster than expected and the monetary policy should gradually move to a neutral stance to reduce the side effects of a low interest rate policy," said Bank of Korea governor Park Seung.

South Korean consumers increased spending at the fastest rate for a decade in December and the latest consumer sentiment report shows confidence at a nine-month high in January.

"The rate rise is mainly based on improving consumption indicators," said Park Sany-hyun, an economist at CJ Investment and Securities.