New Bank of England forecasts opened the door on Wednesday for interest rates to rise but Governor Mervyn King warned markets not to jump to conclusions about the timing or speed of any moves.
The Bank's quarterly inflation report suggested expectations it will start hiking rates soon from a record low 0.5 percent were not far off the mark, given that inflation is double its 2 percent target and likely to climb further.
However, there are big divisions on the nine-member Monetary Policy Committee and King, striking a distinctly more dovish tone, said the outlook for the economy and inflation was highly uncertain and insisted no decisions had been made.
Some people are running ahead of themselves and saying that we are pre-announcing or laying the ground for a rate rise, King said. That decision has not been taken and won't be taken until we get to the next meeting or the following meeting, or it may be many quarters.
The pound fell and interest rate futures rallied as some investors had priced in a more hawkish outlook after data this week showed inflation shot up to 4 percent in January.
There is a strong possibility of a rise in interest rates in the middle part of this year, said James Knightley, economist at ING. That said, given our concerns on the growth story we still believe that rates will not rise as much as the market anticipates.
NO HINTS ON TIMING
King said the Bank was bound to raise interest rates at some point, but only if the economy was strong enough to bear it.
The central bank's February report showed consumer price inflation spiking up to between 4 and 5 percent in the middle of this year before falling back to around 1.7 percent in early 2013, a higher forecast profile than in November.
The Bank said those forecasts were based on the assumption that interest rates would rise to 1 percent by the end of this year, hitting 2.1 percent at the end of 2012.
A below-target forecast would normally imply that markets are pricing in too much tightening. But a key section of the report said that taking all risks into consideration, inflation appeared to be on course to approach the target in the medium term, indicating that rates will rise slowly.
Under the assumptions that Bank rate moves in line with market interest rates ... the chances of inflation being either above or below the target in the medium term are judged to be broadly balanced, the report said.
Inflation has been above target for a whole year, leading some economists to question the BoE's inflation-fighting zeal.
King himself wrote a letter to the government on Tuesday saying price pressures could fall into line if rates rise as markets predict.
That caused the pound to soar since markets are pricing in a May rate rise but on Wednesday he insisted the Bank was in no way endorsing market expectations.
We're not. We never do, he said.
But he admitted there were sharply differing views on the Monetary Policy Committee of interest rate setters.
Minutes to January's policy meeting showed two MPC members voted to raise rates last month, indicating a shift toward a more hawkish stance.
However, there are also those on the MPC who have held a much more dovish view. Minutes from February's meeting will be published next week when the vote could have been even tighter.
The BoE predicted a bumpy ride for the economy this year, with its 2011 forecasts for growth lower than those in its November quarterly forecasts, but it is seen picking up to around 3 percent in the medium term.
That economic uncertainty leads some economists to believe that markets are too hasty in pricing in a May rate rise with sharp government spending cuts only beginning to bite.
On balance, we feel the first rate hike is most likely to come in August, said Hetal Mehta at Daiwa Capital Markets.
(Editing by Mike Peacock)
(Additional reporting by Christina Fincher, Olesya Dmitracova, Avril Ormsby, Keith Weir, Adrian Croft and David Milliken)