LONDON The Bank of England shocked financial markets on Thursday when it said three of its policymakers voted for an interest rate hike, the closest it has come to raising rates since 2007, despite signs of a slowdown in Britain's economy.
The unexpectedly tight 5-3 vote adds questions over monetary policy to uncertainty over Britain's political outlook since Prime Minister Theresa May failed to win a parliamentary majority in an election last week.
BoE policymakers Ian McCafferty and Michael Saunders joined previous rate rise advocate Kristin Forbes in voting to reverse the BoE's decision last August to cut rates to a record-low 0.25 percent, the BoE said.
Governor Mark Carney and the four other members of the Monetary Policy Committee voted to leave rates unchanged.
Financial markets were pricing in a roughly 50 percent chance of an interest rate hike by next June, compared with 20 percent earlier this week, Societe Generale fixed income strategist Jason Simpson said.
But many economists said they still saw no rate hike on the horizon possibly for another two years.
Sterling jumped almost a cent against the U.S. dollar after the decision but it pared gains as doubts grew about whether an outright majority of Bank officials would back higher rates in the foreseeable future
"Last week's election unexpectedly gave us a hung parliament, and now it seems the MPC is also split down the middle," HSBC economists Elizabeth Martins and Chris Hare wrote in a note to clients.
"We think there could be a protracted period of split votes, as political uncertainty, waning growth momentum and weak wages weigh against the case for tightening," they added.
Britain's economy slowed sharply in early 2017 as consumers felt the pinch from higher inflation and slowing wage growth.
That had led most investors to think it was unlikely that the BoE would quickly follow the lead of the U.S. Federal Reserve which raised interest rates for the second time in three months late on Wednesday.
Economists polled by Reuters had expected only Forbes, whose MPC term expires at the end of the month, to back higher rates.
Attention is now turning to the future make-up of the MPC.
Finance minister Philip Hammond has yet to announce replacements for Forbes and for former deputy governor Charlotte Hogg, who quit earlier this year after lawmakers criticised her failure to declare a potential conflict of interest.
Hammond and Carney had been due to address an annual dinner for financiers in the City of London later on Thursday. But the event was cancelled out of respect for victims of a deadly fire in a London apartment block on Wednesday.
Rising inflation and a further fall in the pound have become the BoE's main concerns since its last rates meeting in May.
The BoE said on Thursday that a recent jump in inflation to 2.9 percent meant it was likely to exceed 3 percent this autumn - higher than the BoE forecast just a few weeks ago and well above its 2 percent inflation target.
The fall in the pound after last week's election could push prices yet higher, the central bank said.
Prime Minister May is trying to get a commitment of support from Northern Ireland's main pro-United Kingdom party to allow her to pass legislation.
The pound shed 2.5 percent of its value since the last BoE meeting and is now 13 percent weaker than before Britain voted to leave the EU.
Britain's economy was the worst performer among the world's top seven advanced economies in the first quarter of this year as the effect of higher inflation - partly due to a weaker pound - caught up with consumers at a time of sluggish wage growth.
Retail data released earlier on Thursday showed the joint slowest growth in sales volumes in four years.
But the BoE said it was unclear how long the consumer weakness would last as confidence surveys have looked solid. Moreover, indicators of investment and exports looked upbeat, and unemployment was its lowest in over 40 years, the BoE said.
"The continued growth of employment could suggest that spare capacity is being eroded ... and, all else equal, reducing the MPC's tolerance of above-target inflation," the BoE said.
Key considerations for future rate rises would be inflation pressures, whether consumer demand stayed weak, and if other sources of demand such as exports and business investment grew to compensate, the central bank added.
(Editing by Hugh Lawson)