The economy faces substantial headwinds despite recent signs of recovery, Bank of England Governor Mervyn King warned on Wednesday, leaving the door to more stimulus slightly open after the bank presented new, higher inflation forecasts.
The Bank raised the key medium-term forecast in its latest inflation report to close to its 2 percent goal, indicating that another dose of quantitative easing beyond the 50 billion pounds agreed last week may be less certain than economists expected.
But with the government's hands tied by its pledge to erase a huge budget deficit, the pressure to boost the economy remains firmly on the Bank.
The governor said more easing was possible if needed, but he again rejected calls to support credit-strapped firms more directly, saying this was tantamount to subsidising them and a decision for the government to make.
These remain ... challenging times for the UK economy. Substantial headwinds are hampering our recovery and rebalancing, King said at a news conference, stressing again the dangers posed to Britain by the euro zone debt crisis.
Nevertheless, growth is likely to recover gradually, supported by rising real incomes and the additional stimulus provided by the asset purchases announced last week, King said.
Inflation looks set to fall from the 3.6 percent hit in January as weak growth in the coming months pushes up unemployment and spare capacity in the economy, and bears down on wages and prices.
Chocolate maker Thorntons became the latest retailer to report a hit to its profits because it had to lure cash-strapped Britons with hefty discounts.
Signs have been mounting that Britain may have avoided a renewed recession despite the contraction at the end of 2011.
Even the labour market showed unexpected signs of resilience. The unemployment rate stabilised at 8.4 percent in December and the jobless numbers dipped compared with November as employment rose and firms offered more jobs.
QE QUESTION MARK
Before the forecast update, economists polled by Reuters had expected the central bank to extend its asset purchases again in May. But the new inflation projections raised doubts about the Monetary Policy Committee's readiness to do more.
The report indicated that the MPC does not see a strong case for more QE, although it retains a bias toward further loosening, Barclays economist Simon Hayes said. The report therefore places a big question mark over whether more QE is likely in May.
The March gilt future fell sharply immediately after the report was published, but recovered during the course of King's press conference.
The Bank upped its inflation forecast for two years from now to around 1.8 percent, higher than most economists had expected.
In its quarterly report, the bank predicted sluggish growth in the short term and said that the euro zone crisis posed the biggest threat to Britain's economic recovery. But it added that a return to average growth was likely within a couple of years.
King said quarterly growth this year was likely to zigzag due to extra public holiday's to mark the Queen's Diamond Jubilee, with a quarter of contraction likely.
Last week the Bank's policy committee voted for 50 billion pounds of quantitative easing over the next three months, taking the total to 325 billion pounds, though some economists doubt whether the vote of the nine policymakers was unanimous.
In the report, the Bank said the pace and extent of future falls in inflation was unclear. Oil prices and the uncertain impact of high unemployment on wages and firms' profit margins made it hard to predict how fast inflation will fall.
There remains a range of views among Committee members regarding the relative strength of the factors affecting the outlook for inflation.
Some MPC members, such as chief economist Spencer Dale, have been concerned that past Bank forecasts were overoptimistic about how fast inflation would fall, worrying about a loss of productivity in the economy.
(Additional reporting by Olesya Dmitracova, writing by Sven Egenter, editing by Anna Willard)