Benign inflation environment may not last - BoE

Inflation has been unusually low and stable over the last decade but this benign situation may not last, the Bank of England said.

In a report for parliament's Treasury Committee, the central bank also said that the current account will eventually have to move to balance and this would require a depreciation of the real effective exchange rate.

Sterling fell sharply after the comments.

The BoE, which left interest rates steady this month after three rises since August, also noted that sharply rising asset prices could raise the risk of a future correction.

"In principle, policymakers should take account of this possibility and may therefore decide to raise interest rates and undershoot the inflation target in the near-term in order to increase the chances of meeting it further in the future," the report said.

"Moreover, they should also want to reduce the future volatility of inflation and output, strengthening the case for preventing financial imbalances building up in the first place."

But it noted that actually taking such action was hard given uncertainty about the cause of the rise in asset prices, the likelihood of a correction and what effect higher rates will have.

Still, interest rate futures ticked lower as dealers said the report reinforced expectations that the BoE would raise borrowing costs again in the next few months to contain medium-term inflationary pressures.

The BoE said the strength of domestic demand had been reflected in the balance of payments even if those were somewhat distorted by VAT (Value Added Tax) fraud.

"At some stage, the current account gap will probably need to close. At that point, in order to shift resources from the non-tradable sector of the economy into the internationally tradable part, some depreciation of the real exchange rate will probably be necessary," the report said.

Sterling fell 0.7 US cents and hit a six-week low against the euro but analysts cautioned against reading too much into the comments.

"It seems to be talking about the longer term perspective. Viewed in that context perhaps foreign exchange markets reacted a little bit aggressively," said David Page, economist at Investec.

The BoE also noted that some aspects of the global economy looked unsustainable - "particularly the pattern of global current account imbalances and the low level of real interest rates and risk premia."