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* Graphic: sterling and gilt yields bit.ly/2dgAXn1
* Graphic: sterling year-to-date tmsnrt.rs/2egbfVh
By Jemima Kelly
LONDON, Oct 14 (Reuters) - Yields on 10-year British government bonds on Friday hit their highest level since June's vote to leave the European Union and sterling held near record lows as investors bet the currency's plunge would send inflation soaring.
Bank of England Governor Mark Carney told a public meeting he was willing to allow inflation to run "a bit" higher than the central bank's 2-percent target to help employment and allow Britain's economy to grow.
His comments were echoed by fellow BoE policymaker Kristin Forbes, who said inflation was already picking up, would accelerate and could "sharply" overshoot the BoE's target over the next two years.
Inflation is widely expected to rise above 2 percent in 2017 because of a sharp fall in the value of the pound - a 16 percent tumble to record lows in trade-weighted terms.
At the same time, the economy is expected to slow as Britain begins the complicated process of leaving the EU and tries to negotiate new trade deals, leaving the economy facing a potentially toxic mix of a tumbling currency, rising bond yields, accelerating inflation and sluggish growth.
Ten-year gilt yields rose more than 10 basis points to 1.149 percent, their highest level since Britain's June 23 Brexit referendum. The rise in yields pushed the gap over benchmark German Bund yields to about 107 bps - its widest since late June.
"There's been a huge increase in inflation expectations and bond yields are catching up," said Lyn Graham-Taylor, fixed income strategist at Rabobank.
Sterling and gilt yields had until about two weeks ago moved largely in sync, following the usual developed-market model of higher market interest rates drawing in flows of capital.
But since sterling's latest lurch downwards on worries Britain will undergo a "hard Brexit", yields have begun to reflect concerns about UK inflation.
Gilt yields last Friday posted their biggest weekly rise since August 2015, climbing 30 bps, and were on track to end this week with a rise of about 15 bps.
Their bounce also reflects a broader rise in yields across bond markets on the view that central banks are reaching the limits of their policy of monetary easing, and that the U.S. Federal Reserve will hike interest rates this year.
In contrast to gilt yields, sterling has lost almost 2 percent against the dollar this week. It was trading down a third of a percent on Friday at $1.2210 and on track for a fortnightly fall of almost 6 percent, its biggest since late June.
The pound's fall has stoked demand for inflation-linked bonds, which has pushed real yields - nominal yields adjusted to remove the effects of inflation - close to record lows.
"It's a combination of the result of rising yields globally, the political noises about some of the negative impacts of QE, and because of a rise in inflation expectations going forward as a result of the fall in the pound," said Insight's head of currency investment and fund manager Paul Lambert.
The volume and value of UK government bonds changing hands since the vote for Brexit has soared by as much as 400 percent, figures from Trax - a subsidiary of MarketAxess - showed earlier this week.
Sterling's plunge has also boosted the many internationally-focused, dollar-earning companies on Britain's blue chip FTSE 100 index, which enjoy a currency-related accounting lift as those dollars are converted back into pounds.
The FTSE 100 stands more than 11 percent above its pre-Brexit level, while the more domestically-exposed FTSE 250 has gained nearly 4 percent.
While a drop in sterling hampers British mid-cap firms, which are seen as a play on the UK economy, they have been lifted by better than expected post-Brexit economic data, as well as the prospect for further M&A activity as foreign companies seek out corporate bargains in the UK.
As sterling fell, the FTSE 100 rose 0.9 percent on Friday. The FTSE 250 was up 0.8 percent, underpinned by a surge in MAN Group's shares.
Additional reporting by Patrick Graham, Dhara Ranasinghe and Kit Rees; Graphic by Marc Jones; Editing by Tom Heneghan