* BoE shocks markets, raising QE to 175 bln stg from 125 bln
* BoE says trough in output close at hand
* BoE still worried about tight credit as risk to recovery
* Pound dives and gilt futures soar on surprise decision
(Adds Reuters poll)
By David Milliken and Matt Falloon
LONDON, Aug 6 (Reuters) - The Bank of England took a far bigger step than expected to boost Britain's recession-hit economy on Thursday, stunning markets by expanding its quantitative easing plan to 175 billion pounds from 125 billion.
The central bank said Britain's downturn appeared to have been deeper than previously thought and, while the trough in output was near and some recovery was on the way, tight credit conditions would remain a considerable drag.
The decision shocked many investors who had been starting to take a brighter view of the British economy, especially after recent economic data suggested the year-long, steep recession may have ended in the third quarter.
Economists had been split on whether the BoE would increase its quantitative easing scheme, completed last week, or pause to gauge what impact it was having. Few had forecast an expansion above the original government-set limit of 150 billion pounds.
"This is a huge surprise," said Ross Walker, UK economist at Royal Bank of Scotland. "All the rhetoric seemed to point to not doing very much more, even up to 150 (billion) seemed odds-against after the better (economic) surveys."
The pound fell more than a cent against the dollar and gilt futures rocketed higher after the BoE's decision, which also saw interest rates kept at a record low of 0.5 percent.
Markets will now await the central bank's quarterly inflation forecasts -- due next Wednesday -- for a further explanation of the decision.
"I would not want to say this is the end of it -- if they decide in three months' time that the economy still needs more stimulus they might actually do more," said Jonathan Loynes, chief UK economist at Capital Economics.
Median forecasts from a snap Reuters poll of around 50 analysts showed suggest the BoE will cap its quantitative easing (QE) programme at 175 billion pounds ($297.3 billion), although a third said it could expand it further. [ID:nL6270598]
On a positive note, the BoE pointed to a stabilisation in Britain's main export markets, an easing in financial markets and bank funding, and an improving consumer and business mood.
But analysts say Thursday's move suggests the Bank's new forecasts will still show inflation undershooting its two percent target in the medium term due to the deeper than predicted recession and big headwinds to recovery.
Finance minister Alistair Darling, approving the expanded QE programme, said raising the limit would help the BoE to avoid such an undershoot.
There have been concerns policymakers' unprecedented efforts to boost money flows through the economy by buying bonds with newly-created cash may not be filtering down to credit-starved businesses quickly enough.
"As has always been clear, it will take some time for the full effect of the programme of QE to have its impact," Treasury minister Stephen Timms told Sky News.
The BoE, which says it could take about 9 months for the impact of QE to become visible, said the big stimulus from a weaker pound and monetary and fiscal policy was still working its way through -- but lending to firms had actually fallen.
Analysts say it is really too early to tell if QE is working yet but, with banks busy repairing balance sheets after the worst financial crisis in living memory, policymakers will be extra wary of any signs of a prolonged lending blockage.
For now, the central bank will continue its programme of government bond purchases -- started in March -- for another three months, with an expanded range of gilt maturities. The scale of it will be kept under review.
The BoE had faced a dilemma at its Aug. 5-6 policy meeting. Halting the QE process too early could prolong Britain's worst recession in decades, but doing too much risks setting the stage for an inflation surge in several years time. (Additional reporting by Fiona Shaikh; editing by Stephen Nisbet)