Sterling jumped to a session high near $1.65 and gilts tumbled as investors bet UK rates would rise before the end of the year, rather than at the start of 2012 as they had recently assumed.

“Bank Rate will need to rise at some point. It cannot stay at this level indefinitely,” Bank Governor Mervyn King told a news conference following the publication of the Bank’s quarterly inflation and growth projections.

“That doesn’t tell you, I’m afraid, when Bank Rate will rise,” he added, noting the unusually high level of risks surrounding the outlook for the British economy.

The Bank has held borrowing costs at a record low 0.5 percent since March 2009, but the nine-member Monetary Policy Committee has been split for months about whether to raise rates. Three members voted for a rise in April.

The central bank said the near-term outlook for inflation had worsened due to higher energy costs. Inflation was likely to hit 5 percent this year and was “more likely than not” to remain above the 2 percent target throughout 2012, it said.

It forecast consumer price inflation would be just below 2 percent in two years’ time, up from a forecast of 1.6 percent in February’s inflation report.

Money market rates swung to imply around a 90 percent chance of a rate hike by November, and a more than 50 percent chance of one by September.

“The Bank of England’s inflation report suggests that, in the Bank’s view, the market has perhaps gone a little too far in not expecting an interest rate rise this year,” said James Knightley at ING.

CLOUDY OUTLOOK

The report highlighted a “wider than usual” range of views on the Monetary Policy Committee and said the outlook for inflation and growth were plagued by “substantial” uncertainty.

Britain’s economic recovery has stalled in the last six months and massive public spending cuts that are now starting to bite pose a serious threat to consumer demand.

Retailers Sainsbury’s and Kesa both warned of a challenging year ahead on Wednesday as consumers tightened their belts.

Bank head King said data showing exports grew strongly in the first three months of this year confirmed that a much-needed rebalancing of the economy was in train, although he warned it was a process that would last several years.

The Bank said that the chances of inflation either exceeding or undershooting its 2 percent target on a two year horizon were judged to be roughly balanced — though a chart showed that the odds had moved slightly in favour of an overshoot.

“At first sight the inflation report suggests a rate rise at the end of this year is consistent with meeting the inflation target in the medium term,” said Philip Shaw, an economist at Investec.

While the report was more hawkish than some in the market expected, King noted that oil prices had fallen by 10 percent after the central bank finalised its projections.

The Bank said the near-term outlook for growth had worsened since February and that first-quarter growth had been slower than it had predicted — even though it was likely that official GDP data was underestimating the strength of the economy.

It also said that the extra public holiday in April to mark the royal wedding and disruption to supply chains due to Japan’s March earthquake and tsunami were likely to make quarterly GDP growth rates more volatile than normal.

On the two-year horizon, it saw annual growth of just under 2.9 percent, lower than the 3.1 percent it predicted in February.

“We are facing a difficult time ahead with a slow and prolonged adjustment to the consequences of the banking and financial crisis,” King said.

(Writing by Mike Peacock and Christina Fincher; Additional reporting by Sven Egenter, Peter Griffiths, Olesya Dmitracova and Nia Williams; Editing by Hugh Lawson, Ron Askew)

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