LONDON (Reuters) - Sterling climbed to a seven-year high against the euro and a six-year peak on a trade-weighted basis on Thursday, after the Bank of England said inflation would return to its 2 percent target, keeping alive chances it will raise rates early in 2016.
Investors are factoring in chances the first increase will come in 12 to 15 months time, based on the sterling overnight interbank average rates. They had pushed back those expectations to about 18 months at the end of January.
Sterling hit a six-week high of $1.5388, up from $1.5226 before the central bank released its quarterly inflation report. The pound was also helped by disappointing U.S. retail sales data that weighed on the dollar.
Sterling also rose to 73.715 pence per euro, its highest in seven years. Consequently, sterling's trade-weighted index rose to 90.5, its highest in over six years.
BoE Governor Mark Carney said he expected inflation rates to fall below zero in coming months as oil prices dropped, but stressed that would not mean the economy had entered deflation. He said the BoE's next move was likely to be a rate increase.
The inflation report also included higher forecasts for growth and wage increases. Looking beyond falling oil prices in the short term, the BoE forecast inflation would reach its 2.0 percent target in two years' time and a fraction above that in three years.
"Higher growth and inflation forecasts later in the horizon send a more constructive message that policy risks are in the tighter direction," said Josh O'Byrne, currency strategist at Citi. "This much is supportive for sterling in the near term and likely to lead to a rally as the market digests the message further."
Last week, the BoE kept rates unchanged last week at record lows. At its meeting in January, two policymakers who had previously voted for an increase dropped their call as inflation tumbled to decade lows and wage growth remained subdued.
But recent data has shown a pick-up in manufacturing, and a slew of robust private-sector surveys provided an encouraging picture for the UK economy in January.
"We maintain our forecast that the BOE will leave rates unchanged during 2015 and the first hike to take place in February 2016," said Richard Falkenhäll, senior currency strategist at SEB.
Since the BoE was one of few central banks that had refrained from easing, Falkenhäll said, sterling would be supported against most other currencies, except the dollar. He forecast euro/sterling to fall towards 72 pence by mid-2015.
Reporting by Anirban Nag; Editing by Larry King