The Bank of England suggested that there won't be an interest rate hike this year, pushing expectations of a rise back to 2016, as inflation is expected to fall below zero in coming months.
"Market interest rates imply that Bank Rate is expected to increase from mid-2016 to a little over 1 percent in three years' time, materially lower than had been implied three months ago," according to the central bank's Inflation Report, published Thursday.
In an open letter to the Chancellor of the Exchequer, also published Thursday, Bank of England Governor Mark Carney said the current period of falling prices was "temporary" and a "fundamentally distinct phenomenon from deflation."
Data published last month revealed that the rate of inflation in the U.K. fell to 0.5 percent in December year-on-year -- its lowest level in 14 years.
Sharp falls in food and energy prices, which Carney said were generally good things for U.K. households, were largely to blame for weak inflation.
"Indeed, temporarily negative inflation rates driven by falls in commodity prices actually boost households' real take home pay, particularly if wages are growing. This is clearly the case in the U.K. at the moment," he said in the letter.
In a press conference Thursday, the central bank head added that this weakness masked "stronger underlying dynamics" in Britain.
Carney said he expected inflation to hit the Bank's 2 percent target within two years' time, sooner than earlier forecasts.
However he also stressed that Monetary Policy Committee was ready to take action when needed -- and would even cut the Bank of England's main interest even further below it record low level of 0.5 percent if growth and inflation prospects deteriorated.
"The Bank of England presented a surprisingly upbeat view of the UK economy's outlook at the publication of its latest quarterly Inflation Report, but managed to also raise concerns that it sees the possibility of having to cut interest rates in the event of a deflationary spiral setting in," chief economist at Markit, Chris Williamson said.
"The Bank expects the economy to continue along what's really a quite remarkable recovery path, growing 2.9 percent in both 2015 and 2016. Unemployment is set to fall to 5 percent (a rate not seen since 2005) by the end of the two-year forecast horizon," he added,
Sterling rose towards a seven-year high against the euro and gilt yields climbed after the Governor struck a mostly positive tone in the report.
Sterling hit the day's high of $1.5340 and firmed to 73.91 pence against the euro, up around 0.7 percent on the day.