he Bank of England hinted on Wednesday that interest rates may need to start rising in just over a year as it broadened its guidance on when it will consider the economy to be healthy enough to cope with higher borrowing costs.
The BoE sharply revised up its forecasts for growth over the next three years, recognising the surprise transformation of Britain's growth prospects in 2013.
It said market expectations of a rate hike in the second quarter of 2015 - around the time of a general election in May - were in line with its aim to keep inflation at 2 percent.
But the BoE also said there was enough spare capacity, or slack in the economy, for now to keep rates at an all-time record low level of 0.5 percent without risking a surge in inflation.
It added that any increases in borrowing costs would be gentle.
"The message to businesses, to households is that the Bank rate is going to follow a path that is consistent with jobs, with incomes and with spending growing in a sustainable way," Governor Mark Carney said.
"We are going to calibrate it carefully. We are not going to take risks with this recovery."
Sterling hit a two-week high against the dollar and British government bond prices fell after the Bank's announcement as investors added to bets on a rate hike next year.
The Bank said it will focus on 18 separate measures of the spare capacity in Britain's economy, including business surveys and the number of hours worked.
That contrasted with the guidance adopted by the BoE last August when it said it would consider whether to raise borrowing costs only once unemployment fell to 7 percent.
Since August, unemployment has tumbled and stands at 7.1 percent. The BoE forecast on Wednesday that it will hit 7 percent in the three months to January and will sink further to 6.5 percent by early next year.
"When Bank Rate does begin to rise, the appropriate path so as to eliminate slack over the next two to three years and keep inflation close to the target is expected to be gradual," the Bank said.
BACK TO THE FUTURE?
The broader approach on a range of indicators represents something of a return to BoE statements before the adoption of forward guidance last year.
Peter Dixon, an economist at Commerzbank, said spare capacity was a "nebulous concept" which was hard to measure and markets would be hanging on the BoE's judgment.
"We have more clarity about one thing, however - the BoE is determined to keep rates on hold for a long time to come," Dixon said.
Carney stuck by the BoE's decision of last year which was taken just over a month after he joined the Bank.
"Forward guidance is working," he said. "Expected interest rates have remained low even as the economy has recovered strongly, uncertainty about interest rates has fallen, and most importantly, UK businesses have understood the message."
In a quarterly update of its economic outlook, the BoE said interest rate increases in line with current market expectations seemed consistent with keeping inflation close to its 2 percent target. It added that markets priced in a first rate rise in the second quarter of 2015.
The Bank also said British interest rates were likely to remain well below the 5 percent average before the financial crisis for the foreseeable future.
Britain's economy has grown at an annualised rate of 3 percent since August. But output is still 2 percent below its 2008 peak, unlike many other advanced economies, which have more than made up the damage caused by the financial crisis.
The BoE revised up its growth forecast for 2014 to 3.4 percent from 2.8 percent, a much more bullish forecast than that of most economists.
Inflation has fallen unexpectedly rapidly to its 2 percent target and the BoE said it expected it to dip further to 1.7 percent by March, before hovering close to 2 percent for the next couple of years.
However, the BoE said it was now more pessimistic on the outlook for British productivity than three months ago, as it had failed to keep up with rises in output.
Economists polled by Reuters last month did not expect the BoE to raise rates until the second quarter of 2015.