LONDON (MNI) - The Bank of England's February Inflation Report is likely to justify only modest policy tightening, with inflation on unchanged rates likely to be shown coming in above target at the end of the two year forecast horizon.

On market interest rates, analysts think inflation will be projected below target two years out, with the BOE forecasts endorsing the view that only relatively small increases in Bank Rate will be needed to get inflation back on track.

In the November Inflation Report, the BOE predicted that on unchanged Bank Rate of O.5% CPI would already be on the cusp of the 2.0% inflation target by Q3 2011 (1.99%) and would be well above it by Q4 of the same year (2.35%). The February report will roll this forecast on into Q1 2012, and analysts expect the rising profile of the forecast to again show inflation well above 2% in Q1 2011.

Malcolm Barr, economist at JP Morgan, predicts that on unchanged rates the BOE will show CPI at 2.15% in Q1 2012 but at just below 1.8% two years ahead on market interest rates.

BOE Has Consistently Underestimated Inflation

The BOE has some tricky issues to address in the February Inflation Report. Inflation has persistently come in higher than the central bank has predicted.

All of the quarterly Inflation Reports published in 2009, for example, managed to underestimate Q4 CPI. On flat interest rates the February Inflation Report predicted it would be 0.64%, the May one 0.35%, the August one 1.28% and the November report projected it at 1.85%. The actual level of average Q4 CPI was 2.1%.

The November report then predicted CPI would rise to 2.71% in Q1. The BOE will surely have to raise the forecast in its February Report.

"CPI inflation is likely to rise to over 3% for a while, or even higher for even longer were energy prices or indirect taxes to increase further," Bank of England Governor Mervyn King said in a speech on January 19.

The reversal of the VAT cut in January is one factor driving up inflation, the weakness of sterling another. The BOE appears to have underestimated the speed and strength of the pass-through from the fall in sterling to inflation.

The central bank may upgrade its assessments of the pass-through from sterling moves to inflation, but sterling in any event has recovered some ground since November.

For its forecasts, the BOE uses a 15-day average for trade weighted sterling. On Market News calculations, up until Thursday that stood at 81.2, compared with 80.2 in the run up to the November report. a near 1.2% rise.

The BOE's big inflation picture is likely to remain in place, of inflation falling back still further after a near-term spike to 1.1% in Q1 2011 on market rates (1.2% on flat) before accelerating to 1.7% by Q4 2011.

"Provided monetary growth remains well under control - and remember that at present it is undesirably low - inflation should return to target in the medium term," King said.

Michael Saunders, economist at Citi, said in a research note that he expected the February Inflation Report to show CPI spiking above 3% in the near term before falling below 2.0% in 2011.

Saunders too expects the projection on flat 0.5% Bank Rate to be above target two years out with that on market rates a little below.

The BOE's inflation projections based on market interest rates can be trickier to predict, as they obviously depend in part on what the BOE plugs in for rate expectations. The central bank has varied its methodology for stripping out rate expectations.

In the November Inflation Report it used averages of one-day forward rates based on overnight index swap (OIS) rates.

These showed markets pricing in the first rate hike in Q3 2010, with Bank Rate rising from its current 0.5% to 1.1% in Q3, 1.6% in Q4 and on up to 3.2% in Q4 2011.

Current rate expectations are for a slower pace of monetary tightening. The sterling overnight index average (SONIA) is currently only fully pricing in the first hike by December this year with Bank Rate only rising 46 basis points in the next 12 months. It was pricing in 61 basis point worth of hikes before the BOE Monetary Policy Committee's February meeting.

One potential source of confusion is that the bases for the BOE February projections will be above current market assumptions and levels. Nick Bate, economist at Bank of America Merrill Lynch notes that market rate expectations are now clearly lower than they would have been in the 15 working days average the BOE uses for its projections and oil prices will also be lower.

Also, last week's sharp equity sell-off and yield spread widening will have come too late to have much influence on the central bank's projections. With gaps between current market rate expectations and what is factored into the Inflation Report, David Page, economist at Investec, says that the BOE's flat Bank Rate assumptions are a more useful guide for thinking about the policy outlook than the market rate one.

If Malcolm Barr, cited above, is right in thinking the flat rate forecast is likely to show inflation at 2.15% in Q1 2012, ie within a whisker of the target, the report is likely to be seen as validating only marginal policy tightening - ie hikes of a similar magnitude to those already priced into the market.

The BOE, many analysts say, see this Inflation Report as a holding operation, given the high degree of uncertainty in the outlook - ie a looming election, the impact of fiscal tightening and the downside risks on growth. The BOE will be happy with the markets only pricing in minor tightening - and that further out rather than nearer in.

Growth Forecast Could Be Lowered

While the lower rate expectations will push up on the inflation profile, the BOE may nudge its growth forecast lower, which will push down on inflation.

The fact the first estimate of fourth quarter GDP data, showing growth of just 0.1% on the quarter, came in below the central bank's estimate may have only a slight impact. The BOE simply does not attach great weight to National Statistics' first GDP estimate.

As King said "the MPC is acutely aware that initial data releases are often later heavily revised" and the BOE will "backcast" the data to show a higher outturn of up to +0.3% on the quarter in Q4.

The Monetary Policy Committee, which signs off on the Inflation Report, may feel that some of its previously noted downside growth risks are crystallizing.

In the November Inflation Report, the BOE's modal, or most likely, forecast showed a robust recovery. King, however, used the Inflation Report press conference to stress the downside growth risks, which drive the central bank's mean growth forecast back down closer to consensus levels.

As King told reporters when comparing the BOE's growth forecast with those of other forecasters "you should bear in mind that there are big downside risks."

The BOE's mean yearly growth forecast in the November Inflation Report for Q4 2010 on market rates was 2.74% compared to 3.74% on its modal forecast, and the 1 percentage point wedge between the mean and modal forecasts persists through to 2012 Q4.

The central bank could leave the downside risks in place, and stick with a broadly similar central, modal growth forecast.

Fathom Financial Consulting, which runs a version of the BOE model, believes the February Inflation Report will show a recovery which is "more U than V, but still implies a robust rebound."

On the Fathom projections, this will still show 2011/2012 as the strongest consecutive years of growth since 1987/88, with 4.0% growth in 2011 and 3.7% in 2012.

JP Morgan's Barr sees the BOE bringing its Q4 2010 growth forecast on a year ago down to 3.2% from 3.74% in November on market rates, and its 2012 Q1 forecast down to 3.4% from 3.84%.

In any event, King will almost inevitably stress again how the output gap will push down on inflation and how downside risks to growth persist.

The Inflation Report will be published at 1030 GMT Wednesday, with Kings' press conference immediately after it.