By David Milliken and Ana Nicolaci da Costa
LONDON (Reuters) - The Bank of England said on Wednesday British interest rates could start to rise from record lows in little more than a year as a rapid recovery brings the economy closer to operating at full steam.
Governor Mark Carney - forced to ditch a previous version of rates guidance after it was overtaken by a sharp fall in unemployment - also announced the Bank would now follow a much broader range of measures of slack in the economy in making rates decisions.
The BoE slashed interest rates to 0.5 percent at the height of the financial crisis in 2009. The economy bounced back strongly last year but remains smaller than before the crisis and Carney stressed any increase in rates would be gradual.
"The message to businesses, to households is that the Bank rate is going to follow a path that is consistent with jobs, with incomes and with spending growing in a sustainable way," he
said. "We are going to calibrate it carefully. We are not going to take risks with this recovery."
The central bank said a view in financial markets that rates could rise in the second quarter of next year - around the time of a national election - was consistent with its goal to keep inflation close to its 2 percent target.
It also pointed to market expectations that its interest rate would stand at 2 percent in three years' time, a timeframe supported by a Reuters poll of economists taken after the BoE announcement.
Sterling hit a two-week high against the dollar and British government bond prices fell after the Bank's announcement as investors added to bets on a rate hike next year.
The Bank said it will focus on 18 separate measures of the spare capacity in Britain's economy, including business surveys and the number of hours worked, something economists said would make it hard to guess the BoE's next moves.
The array of indicators contrasted with the guidance adopted by the BoE last August when it said it would consider whether to raise borrowing costs only once unemployment fell to 7 percent.
The jobless rate has since tumbled to 7.1 percent. The BoE forecast on Wednesday it will reach 6.5 percent in early 2015.
"When Bank Rate does begin to rise, the appropriate path so as to eliminate slack over the next two to three years and keep inflation close to the target is expected to be gradual," the Bank said.
The BoE for the first time estimated how much slack is in the economy - around 1.0-1.5 percent of gross domestic product, lower than some other economists' estimates.
Deputy Governor Charlie Bean said rates would need to rise before the spare capacity was completely used up, or the central bank would risk being behind the curve.
The BoE's dilemma is shared with other central banks in advanced economies that are healing from the crisis. The U.S. Federal Reserve is struggling with how to scale back exceptionally stimulative monetary policy without slowing the recovery too much.
BACK TO THE FUTURE
The BoE's latest approach to explaining the policy path ahead represents a partial return to the situation before the adoption of forward guidance last year. Then, economists scrutinized small changes in the Bank's inflation forecasts for signals about whether policy was too loose or too tight.
How the new estimates of slack will influence BoE inflation forecasts and its policy decisions could prove hard to predict.
Peter Dixon, an economist at Commerzbank, said spare capacity was a "nebulous concept" and markets would be hanging on the BoE's judgments. "We have more clarity about one thing, however - the BoE is determined to keep rates on hold for a long time to come," Dixon said.
A further complication is that a rate rise now looks most likely around the date of Britain's next national election in May 2015, at which public perceptions of living standards look set to be a key issue.
In the face of some critical questions from reporters about the credibility of the BoE's new plan, Carney stuck by the BoE's decision to launch forward guidance last year.
"Forward guidance is working," he said. "Expected interest rates have remained low even as the economy has recovered strongly, uncertainty about interest rates has fallen, and most importantly, UK businesses have understood the message."
The BoE revised up its growth forecast for 2014 to 3.4 percent from 2.8 percent, a much more bullish forecast than that of most economists.
Inflation has fallen unexpectedly rapidly to its 2 percent target and the BoE said it expected it to dip further to 1.7 percent by March, before hovering close to 2 percent for the next couple of years.
The BoE said it was now more pessimistic on the outlook for British productivity than three months ago, as it had failed to keep up with rises in output. Business investment was likely to pick up but increasing exports would remain a challenge.
(Additional reporting by Kate Holton, Andy Bruce, Li-mei Hoang and Paul Sandle; Editing by William Schomberg and Jeremy Gaunt)