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Sterling strength gives Bank of England rate-setters a headache

By David Milliken

LONDON (Reuters) - As the Bank of England moves closer to raising interest rates for the first time since 2007, the strength of sterling is causing disagreement among its policymakers over when to pull the trigger.

The BoE is due to make a slew of announcements on Thursday, among them its forecasts for inflation, which will give investors a better sense of how soon rates are likely to rise.

The pound hit its highest level in over seven years against the currencies of Britain's main trading partners last month, bolstered by expectations of higher interest rates as the country's economy recovers. This week, the bank will need to take a stand on how long the effect of strong sterling will last.

The BoE's rate-setters must decide whether the effect of cheaper imports and reduced demand for British products abroad will last long enough to justify a cut to its forecast for inflation in two years' time. Private-sector economists would usually interpret this as a sign that the bank is unlikely to raise interest rates in the coming months.

However, some policymakers might still want to tighten policy if other factors - such as the speed at which wages are rising, relative to a small recovery in productivity - point to underlying price pressures in the slightly longer term.

"At that point, the decision on what to do with interest rates becomes more complicated," said Robert Wood, a former BoE forecaster who is an economist at Bank of America Merrill Lynch.

While the BoE typically ignores factors with a brief impact on inflation such as swings in oil and food prices, big currency moves are on the borderline between a short-term and a long-term factor.

British inflation is currently forecast to bounce back from zero to its target of 2 percent within two years. But if Thursday's forecasts show this may take rather longer, the chances of a rate rise before early next year will fade.

SPLIT EMERGING?

BoE policymakers have already disagreed on how much the strength in sterling is likely to offset the impact on inflation of rising wages, according to minutes of their meeting in early July, and some are expected to vote for a rate hike this week.

Governor Mark Carney struck a more cautious note on July 16, saying an 18 percent rise in sterling over the past two years could have a "sizeable" and "potentially protracted" effect.

The need for a rate hike should become clearer around the end of the year, he said.

This week, he is likely to be wary of driving sterling up by talking up the prospect of a British rate rise while the timing of a similar move by the U.S. Federal Reserve remains uncertain.

The last time Britain was hit by a similar-sized currency shock - when sterling weakened by more than a quarter at the start of the financial crisis - the impact on inflation lasted much longer than the BoE forecast at the time.

This time, import prices have fallen by less than the BoE expected. But policymakers might decide the impact of sterling strength is simply taking longer than usual to have an effect.

"Pass-through is one of those movable feasts," Wood said. "It can be bigger or smaller depending on the state of the economy at the time. It's very hard to predict."

(Editing by William Schomberg and Hugh Lawson)