SINTRA, Portugal (Reuters) - A rise in British interest rates is likely to be needed as the economy comes closer to running at full capacity and the Bank of England will debate when to do so "in the coming months", BoE Governor Mark Carney said on Wednesday.
In a noticeable shift in emphasis since his last speech on June 20, Carney did not repeat his phrase from then that now was not the time to raise rates. Markets immediately priced in a greater chance of an early rate rise.
The pound rose to its highest level since Britain's June 8 election after the BoE released Carney's remarks. Gilt yields jumped as one measure of rate hike expectations rose to its highest since last year's vote to leave the European Union.
Addressing the European Central Bank conference in Sintra, Portugal, Carney said policymakers would need to look at the extent to which stronger business investment offset a slowdown in consumption, as well as growth in wages and labour costs.
"These are some of the issues that the MPC (Monetary Policy Committee) will debate in the coming months," Carney said. "Some removal of monetary stimulus is likely to become necessary if the trade-off facing the MPC continues to lessen and the policy decision accordingly becomes more conventional."
The MPC split 5-3 earlier this month on whether it was time to start to raise British interest rates from a record-low 0.25 percent.
"As spare capacity erodes, the ... (MPC's) tolerance for above-target inflation falls," Carney said.
Britain was the fastest-growing major advanced economy last year, but quarterly economic growth slowed to just 0.2 percent in the first three months of 2017. However, last month the BoE still forecast that growth this year would be only slightly below Britain's long-run trend at around 1.9 percent.
British inflation hit its highest in nearly four years at 2.9 percent last month, well above its 2 percent target, prompted by the pound's post-Brexit vote tumble.
Policymakers are unsure about how much of the slowdown in consumer spending will be offset by stronger exports and investment.
Moreover, wage growth -- which some policymakers see as a key gauge of medium-term domestic inflation pressures -- is slowing, and the impact of political uncertainty since the June 8 election and the start of Brexit talks is hard to predict.
"Different members of the MPC will understandably have different views about the outlook and therefore the potential timing of any Bank Rate increase. But all expect that any changes would be limited in scope and gradual," Carney said.
BoE chief economist Andy Haldane -- who less than a year ago defended a "sledgehammer" package of measures to tackle the risk of a post-referendum slowdown -- surprised many observers last week by saying he expected to vote for higher rates this year.
In part this reflects the BoE's expectation that strong global growth -- combined with sterling's big fall -- will lift exports and spur business investment.
Carney also noted on Wednesday that strong world growth would push up global equilibrium interest rates and potentially make British monetary policy more accommodative in comparison.
ING economists said Carney's speech was a "a significant shift in policy bias", but not all economists were convinced his comments implied he would back a rate rise soon.
"The Governor's view continues to be very much 'wait and see'," said Martin Beck of consultancy Oxford Economics.
BoE Deputy Governor Jon Cunliffe also seemed cautious in a radio interview earlier on Wednesday, saying he wanted to see how a squeeze on household income played out.
Reporting by Balazs Koranyi, writing by David Milliken, editing by Andy Bruce/Jeremy Gaunt