Bank sees inflation well above target in 2 years

By Sumeet Desai and David Clarke

LONDON (Reuters) - Inflation will shoot up this year and stay above the central bank's target in two years if interest rates fall, according to Bank of England forecasts, leaving little scope for rate cuts to boost a slowing economy.

In its quarterly Inflation Report published on Wednesday, the central bank painted a bleak view of the immediate future, predicting inflation could near 4 percent and the economy could even contract for a quarter or two.

"The Monetary Policy Committee is facing its most difficult challenge yet," Governor Mervyn King said at a news conference. "We are travelling along a bumpy road as the economy rebalances. Monetary policy cannot, and should not try to, prevent that adjustment"

The June gilt future fell more than half a point on the worsening inflation outlook while back month short sterling futures fell sharply as dealers bet against further rate cuts.

"The Bank of England's May Inflation Report suggests that the MPC will not deliver the rate cuts which the news on the economy suggests are sorely needed," said Jonathan Loynes, chief European economist at Capital Economics.

King admitted that he would probably soon have to write several letters to the government, explaining why inflation was more than a point above the central bank's 2 percent target -- as required by the central bank's remit.

"Grim outlook, implies little scope for easing," said Michael Saunders, economist at Citigroup.

The report showed inflation at around 2.25 percent in two years if interest rates fall by 50 basis points as expected by markets. It is rare for the central bank to predict such a deviation from the target over such a time frame.