* BoE halves 2014 wage growth forecast to 1.25 percent
* Central bank says wage developments key to rate hikes
* Carney says BoE may have under-estimated economic slack (Adds economist reaction, writes through)
By David Milliken
LONDON, Aug 13 The Bank of England dented expectations of a first interest rate hike this year, slashing its forecast for wage growth and saying higher borrowing costs hinged largely on an improved outlook for pay.
Sterling slumped to a 10-week low against the dollar and bond prices rose as traders saw little prospect of a rate rise before 2015, something BoE Governor Mark Carney had urged them to consider as a possibility just two months ago.
Overall the BoE's quarterly economic update on Wednesday was upbeat, with upgrades to the growth outlook for this year and next, lower unemployment and inflation remaining just below its 2 percent target.
Britain is set to grow faster than any other big, rich nation this year.
But the economy has only just recovered its size of before the financial crisis, far slower than most of its peers, and part of the strong recovery is down to a 10 percent rise in house prices over the past 12 months - raising fears of a new property bubble.
Pay growth has also yet to take off and in its new forecasts on Wednesday, the BoE forecast wage growth of just 1.25 percent this year, half the rate seen in May.
Data showed average wages in Britain fell for the first time in five years during the three months to June, even as the unemployment rate dropped to 6.4 percent, its lowest since late 2008.
Bank Governor Mark Carney said the speed of the fall in Britain's unemployment rate meant there was now less room for growth without inflation than the BoE had forecast earlier this year. But there were also signs that there had been more spare capacity in the first place than the Bank originally forecast.
"Whatever the causes, these developments point to the economy being able to sustain a higher level of employment and lower rate of unemployment without generating additional inflationary pressures," Carney told a news conference.
The Bank indicated that wage developments would be key to the exact timing of a rate move.
"In light of the heightened uncertainty about the current degree of slack, the Committee will be placing particular importance on the prospective paths for wages and unit labour costs," Carney said.
RATES TO RISE?
The BoE's forecasts are based on market assumptions that its Monetary Policy Committee (MPC) will vote to raise rates in February next year, three months earlier than when the Bank published its last forecasts in May.
That timeframe would probably make Britain the first major economy to raise interest rates since the end of financial crisis. But there was little to support a rate rise within the next three months - something which markets had seen before Carney spoke as having a roughly one-in-three probability.
"There is nothing in the Inflation Report and Carney's comments to indicate that the MPC is close to the first hike at present," said Michael Saunders, chief UK economist at Citi.
The central bank stuck with its guidance that when rate rises come, they would be gradual and to a level well below pre-crisis norms - though it cautioned this was not a promise.
The BoE said its policymakers now saw spare capacity in the economy of roughly 1 percent of gross domestic product. This was down from around 1.25 percent it estimated in February and May.
But Carney said policymakers had a wide range of views about how much slack remained, raising the chance that at least one of the nine members of the MPC voted for a rate rise this month. Voting records will published on Aug 20.
The BoE slightly revised up its growth forecast for this year to 3.5 percent from 3.4 percent - which would be Britain's fastest growth rate in more than a decade. Growth in 2015 is likely to be 3.0 percent, again above the long-run average.
It also expects unemployment to drop even more than it forecast before, sinking to 5.4 percent in two years' time, lower than the 5.9 percent it predicted in May.
However, this fall in unemployment does not necessarily point to inflation pressures. The BoE sharply lowered its estimate of the equilibrium unemployment rate - the rate at which the number of people out of work stops weighing on wages - to 5.5 percent from 6.25 percent. (Writing by David Milliken and William Schomberg, additional reporting by Paul Sandle, William James and Andy Bruce,; editing by John Stonestreet)