LONDON, Aug 17 (Reuters): The Bank of England is hoping it can gently wean Britain's economy off record-low borrowing costs, but its plan for "gradual and limited" rises in interest rates might prove harder to pull off than investors expect.
So far, financial markets agree with BoE Governor Mark Carney's reassurances that a return to more normal-looking monetary policy will probably not be a painful one.
Speculation, instead, is focusing on the shorter-term question of whether the Bank's first rate rise since 2007 will come in November, February or even May.
Yet there are a host of scenarios that could require the Bank to step up the pace of rate increases, such as a further run-up in house prices or an inflationary surge in pay.
"At some point their hand may be forced by events," said Andrew Sentance, a former BoE policymaker who has long called for higher rates. "There is a degree of inconsistency in pushing off interest rate rises as long as you can and still saying they can be done gradually."
Britain's economy looks set to enjoy its fastest growth in a decade this year, beating all other major advanced economies, and unemployment has fallen to a five-year low of 6.4 per cent.
At the same time, though, output has only just recovered to pre-crisis levels and wage growth is painfully slow. Inflation is also below the BoE's target and forecast to stay there, making many observers confident that interest rates are set to stay low for the long term.
Carney says the "new normal" for British interest rates is around 2.5 per cent, about half their level before the crisis, and in a newspaper interview on Sunday he said the economy and banks are not yet back to full strength.
Certainly there are strong reasons to expect rates to be lower than before. Greater caution from lenders means that there is a bigger gap between official BoE rates and those charged by banks, making effective interest rates higher.
High household debt levels combined with years of weak wage growth mean that household finances are more stretched than before the crisis. A rise in borrowing costs may thus have a bigger effect on consumer spending than previously.
Moreover, the U.S. Federal Reserve's caution about raising rates, combined with economic stagnation in the euro zone, suggests little upward pressure on BoE rates from abroad.
However, investors seem to give little weight to alternative scenarios that could require rates to rise faster from their record low of 0.5 per cent, where they have been since 2009.
Five-year British government bond yields have hit a nine-month low of 1.74 per cent, reflecting global economic worries more than Britain's medium-term interest rate outlook.
Markets expect the BoE to raise rates by less than a quarter of a per centage point every three months after it starts to tighten monetary policy early next year - an outlook that was broadly endorsed by Carney last week.
Economists expecting an early rate rise were surprised by Carney last week when he suggested that the Bank was in no hurry to change policy and that it was focused on the prospects for wages - by far the weakest part of Britain's economic picture.
"This bias to 'low for longer' increases the likelihood that GDP ... will again outpace the consensus and reduces the likelihood that tightening will be anything like as gradual and limited as markets currently expect," said Michael Saunders, chief UK economist at Citi.
Carney and the BoE have said that the gradualist approach to rate rises is an expectation, not a guarantee.
While stronger than expected growth is one possible cause for higher rates than markets have pencilled in, another would be if the labour market once again defies BoE forecasts.
Price pressures in Britain have so far been muted, with wages staying low despite robust growth and falling unemployment.
The BoE expects wages will pick up in 2015 and 2016, but not by as much as their long-term average. That is partly because it thinks the number of people wanting to work will hit new highs.
The inflation impact of higher wages will be reduced further by a pick-up in workers' productivity, but that is something the Bank has been predicting almost since the start of the crisis.
