The Bank of England is likely to smooth the way for higher interest rates with its Inflation Report today in an attempt to force the cost of living back on target.

　　The dilemma facing policymakers is how to tackle rising price pressures without derailing the economic recovery. Photo: SUZANNE PLUNKETT

　　Wednesday's quarterly economic forecasts from the central bank follow official figures on Tuesday showing inflation running at a two-year high of 4pc - double its target.

　　The dilemma facing policymakers is how to tackle rising price pressures without derailing the economic recovery.

　　"The committee has no choice but to establish its credibility by sounding hawkish," said Amit Kara, economist at UBS.

　　Economists believe Mervyn King, the Governor of the Bank of England, was preparing the way for interest rate rises in his obligatory letter to the Chancellor explaining the price rises yesterday.

　　While he reiterated his belief that "temporary" factors were driving up the cost of living, including high food and energy costs and the increase in VAT to 20pc, he said the Monetary Policy Committee believed inflation will be around target, at 2pc in two or three years, "under the assumption that the bank rate increases in line with market expectations".

　　That could mean up to three rate rises before the end of the year.

　　"The Governor's letter seems to endorse market pricing for the Monetary Policy Committee to hike soon," said Citi economist Michael Saunders.

　　Interest rates have been held at a record low 0.5pc for almost two years but money markets are pricing in rates at 1.25pc by the end of this year, and in general expect a faster pace of tightening over the next two years than they did in November.

　　The Bank produces two forecasts for inflation in its quarterly report - one based on market interest rate expectations and one that assumes interest rates remain at 0.5pc.

　　Analysts reckon that near-term inflation forecasts on both measures will be revised upwards to reflect a greater knock-on impact of rising commodity prices and value-added tax.

　　The November forecasts envisaged inflation falling to a modal 1.45pc in the fourth quarter of 2012 based on market rate expectations, and 1.59pc based on unchanged policy.

　　"For the first time in a while, assessing what happens to monetary policy will depend on both fan charts," said Alan Clarke, economist at BNP Paribas.

　　The Bank's outlook for growth will also play a key role in determining when policymakers start to withdraw monetary stimulus, and so far it has maintained there is enough slack in the economy to keep inflation in check further down the line.

　　The central bank will almost certainly have to revise down its near-term forecasts for GDP from November because of the shock 0.5pc quarter-on-quarter decline in economic output in the final three months of 2010.

　　The contraction was mainly due to heavy snowfall in December, and there are signs that activity rebounded quickly in January.

　　But the Bank may still have to lower its medium-term outlook for growth, lessening the urgency for the MPC to take action on inflation.

　　The Bank's modal projection for year-on-year GDP growth in the fourth quarter of 2010 was 3.05pc - almost double a first official estimate of 1.7pc growth.

　　"That said, most MPC members have clearly become more worried about the damage to credibility that is being wrought by the persistent overshooting of the inflation target," said Simon Hayes, economist at Barclays Capital.

　　"In that case, the report will provide a vehicle to prepare financial markets, firms and households for a rate hike, probably within the next few months."