The Bank of England made a "marked" increase to its near-term inflation forecast

 LONDON (Dow Jones)--The Bank of England made a "marked" increase to its near-term inflation forecast Wednesday, paving the way for earlier interest-rate rises than investors had expected.
        But a downgraded growth forecast balanced the picture, making some economists wary of forecasting near-term rate rises.
        The bank's quarterly Inflation Report pointed to the consumer price index rising by 5.0% later this year and only falling back to the 2.0% target in two years' time if the BOE raises interest rates five times, beginning in the third quarter of this year.
        "The May Inflation Report indicated that a rate hike this year is still on the agenda," said Simon Hayes, economist at Barclays Capital.
        Investors brought forward their expectations for rate increases in response. The sterling overnight index average rate, or Sonia, showed a 94% chance of a BOE rate rise in November, up from 84% before the bank published its report. Sonia, which indicates what banks expect to pay each other for short-term loans, fully priced in a rate increase as early as December, compared with January prior to the report.
        Investors in previous weeks had sharply pared back their forecasts for monetary policy tightening, following a string of weak U.K. economic data.
        In April, the Office for National Statistics estimated the economy grew by just 0.5% in the first three months of the year, only barely making up the for the 0.5% loss in output caused by heavy snow at the end of 2010. Private-sector surveys then pointed to a slowdown in April.
        But BOE Governor Mervyn King said the Monetary Policy Committee thinks the recent "softness" in economic output will prove temporary. The MPC also suggested in the report that U.K. output is being underestimated, and revisions to official data will show the economy in a stronger position.
        Barclays Capital's Hayes said that as long as activity appears stable, the MPC will return its focus to its sole mandate of keeping annual inflation at 2.0%.
        "Our perception is that the MPC has become increasingly uncomfortable with the fact that it keeps pushing out the point at which inflation returns to target, " he said.
        "The MPC's job is to deliver 2% inflation, not simply to forecast it, and the current policy setting looks increasingly unlikely to generate the necessary drop at any reasonable time horizon."
        The BOE said that if interest rates don't rise from their current all-time low of 0.5%, annual inflation will be above target two years from now. Price growth slowed to 4.0% in March, from 4.4% in February.
        King, in a press conference following the report's publication, also said high inflation now could push up wages and inflation expectations, making it that much more difficult to combat price growth.
        But some economists believe the BOE won't make any move to tighten policy until there is proof the economy has regained its footing.
        "We're looking at the economy losing traction in quite a serious way," said Ken Wattret, chief euro-zone economist at BNP Paribas.
        He predicted the BOE will look through the near-term rise in inflation. "If the BOE says inflation is going to hit 5% and it still isn't hiking rates, what will make them tighten in three months' time?"
        Wattret said that as long as uncertainty clouds the economic data, the MPC is likely to maintain its "wait-and-see" stance.
        The BOE's economic growth forecast in the inflation report was lower than in February. It also said the risks to growth are "skewed to the downside."
        King said slow growth is one consequence of the economy rebalancing to a more sustainable footing, away from financial services and domestic consumption and towards manufacturing and exports.
        Data Wednesday were encouraging on that front.
        The ONS said exports in the first quarter of 2011 rose 6.5% to GBP75.0 billion, the highest quarterly figure on record. That meant the first-quarter goods-trade deficit shrank to GBP22.2 billion, from 26.8 billion in the last three months of 2010.

        -By Alex Brittain, Dow Jones Newswires; +44 20 7842 9452; alex.brittain@dowjones.com

        (END) Dow Jones Newswires
        May 11, 2011 10:15 ET (14:15 GMT)