UPDATE 2-BoE implies prolonged loose policy, gilts surge

LONDON, Aug 12 - British inflation will be below target in 2011 if interest rates rise next year and the economy will take a long time to recover properly, the Bank of England said, suggesting markets are pricing in rate increases too early.

Sterling fell a third of a U.S. cent and gilt futures surged after the BoE issued its quarterly forecasts on Wednesday, as investors bet UK rates will stay at a record low 0.5 percent for longer and the central bank could still boost its asset purchase plan.

"The Bank of England's August Inflation Report gives a clear signal that policy is unlikely to be tightened any time soon and certainly does not rule out a further extension of quantitative easing," said Vicky Redwood, an economist at Capital Economics.

The central bank stunned financial markets last week by expanding its QE programme of bond purchases by a much bigger than expected 50 billion pounds because the recession had so far been deeper than it had factored in only three months ago.

BoE Governor Mervyn King said there were signs the UK economy was starting to recover. But he warned that it would take a long time for things to get back to normal and the human cost could be high.

"The big message today from this -- it's levels, stupid. It's not growth, it's levels that matter here," King told a news conference. The large degree of spare capacity in the economy meant unemployment would stay high and continue to rise, he added.

Another 220,000 people became unemployed in the three months to June, official data showed on Wednesday, taking the jobless rate to 7.8 percent -- the highest since 1996.

By contrast the U.S. Federal Reserve, which ends a policy meeting later on Wednesday, is expected to halt its purchases of long-term government securities due to signs that the economy is stabilising from a deep recession.

INFLATION FORECASTS

In its quarterly forecasts, the BoE charts showed economic growth returning at the turn of the year and getting close to a rate of 3 percent in two years' time.

"The stimulus should lead to a slow recovery in economic activity, but the timing and strength of that recovery remains highly uncertain," the BoE said.

The BoE projections showed CPI inflation at around 1.4 percent in two years' time if rates follow the path implied by market expectations -- rising to 0.7 percent in the first quarter of 2010 and going up thereafter.

But assuming interest rates stay at 0.5 percent and the BoE reaches its 175 billion pound quantitative easing target, "the risks of inflation being above or below the 2 percent target at the two year horizon are broadly balanced, albeit that the path of inflation is rising".

While the inflation profile was similar to that published in May, the outlook for growth was "somewhat stronger" given the extra stimulus pencilled in.