Looming inflation surge raises risk of BoE rate hike

* Markets see one-in-five chance of rate rise to 0.75 pct

* Inflation may near 5 pct despite shock fall in Q4 GDP

* New growth and inflation forecasts will aid MPC decision

By David Milliken

LONDON, Feb 10 (Reuters) - Financial markets see a one-in-five chance that the Bank of England will raise interest rates from their record low 0.5 percent later on Thursday after what is likely to be its most finely balanced decision in years.

Such a move would make the BoE the first central bank from a major advanced economy to tighten policy since the start of the financial crisis -- and confound critics who say that the Monetary Policy Committee lacks anti-inflationary zeal. At issue is whether the BoE holds its fire to support growth at a time when economic recovery still looks very patchy, or takes pre-emptive action now to reduce the risk that an imminent spike in inflation will turn into something more permanent.

"The MPC is coming under intensive pressure to raise rates," Bank of America/Merrill Lynch interest rate strategist John Wraith wrote in a note to clients. "It is being led to the brink."

Last month the BoE surprised markets when new MPC member Martin Weale joined long-standing hawk Andrew Sentance to call for a rise in rates to 0.75 percent from a record low 0.5 percent, and other MPC members said their decision was "finely balanced".

Since then economic data has shown an unexpected fall in output in the last three months of 2010 -- due only in part to the coldest December in 100 years -- before an apparent bounce-back last month. Inflation has exceeded the BoE's 2 percent target by at least a percentage point for over a year, and on Jan. 25 BoE Governor Mervyn King predicted it could near 5 percent in the coming months.

But King said inflation remained on track to return to target early next year, so long as the one-off factors pushing it up -- a hike in sales tax, rising oil and commodity prices and past sterling weakness -- did not lift tepid wage growth.

The tension between high current inflation and the BoE's official forecast that it will be well below target in barely a year's time lie at the heart of the split between money market and economists' views of likely BoE policy.

Money markets -- based on futures prices for the cost of overnight interbank lending ICAPSONIA -- see almost a 20 percent chance of a rate rise at 1200 GMT on Thursday and a near certainty of a move by May.

By contrast, fewer than a third of economists polled by Reuters last week expect rates to rise before the final three months of this year. [ID:nLDE7100Q5]

"Although one can never rule out a surprise from the MPC, we think there is insufficient momentum behind the hawks' case for there to be a rate hike this month," said Simon Hayes, UK economist at Barclays Capital.

INFLATION REPORT

Part of the reason economists are sceptical about prospects for a rate rise is the quarterly update to the BoE's growth and inflation forecasts which the MPC will be privy to but which will not be published until next Wednesday.

A key warning signal for the MPC to raise rates is if inflation is forecast to exceed 2 percent in 2 years time -- roughly the time it takes for a change in monetary policy to affect prices. In November's set of forecasts, inflation was pencilled in at below 1.5 percent at this point.

While the sharp rise in oil and other commodity prices since November and the risk of faster wage rises put upward pressure on this forecasts, other factors are pushing down.

For one, the BoE's growth forecasts are higher than the current market consensus. A downward revision would increase the spare capacity in the economy two years hence, putting downward pressure on inflation.

Second, the increase in government bond yields and rise in sterling since November acts as an effective tightening in monetary conditions, lowering the inflation forecast generated by the BoE's models.

This theoretically makes a rise in interest rates less necessary, even if much of this market move has been caused by growing expectations of a rise in official BoE rates.

"The all-important question is whether the combination of those contrasting influences generates a CPI forecast ... that remains noticeably below target," said BofA/ML's Wraith. "In (this) case the market may pare back the degree of certainty with which it is anticipating a May hike." (Reporting by David Milliken; Editing by Ron Askew)