Bank of England holds rates, weighs inflation risks from Iran war

* Bank of England MPC votes 8-1 to hold interest rates at 3.75%

* BoE Chief Economist Huw Pill votes for rate hike to 4%

* BoE sets out new inflation scenarios triggered by Iran war

* Inflation could exceed 6% in early 2027 if oil prices stay high (Updates market reaction in paragraph 4, economist 5-6, Bailey in 7-9 and 18-19)

By William Schomberg, David Milliken and Suban Abdulla

LONDON, April 30 (Reuters) - The Bank of England kept interest rates on hold on Thursday and set out scenarios for the economic impact of the Iran war, the most extreme of which might entail "forceful" rate rises while less damaging outcomes may not require any increase at all. The Monetary Policy Committee voted 8-1 to keep the BoE's benchmark Bank Rate at 3.75% as only Chief Economist Huw Pill sought a hike to 4.0%, in line with expectations in a Reuters poll of economists. A day after the U.S. Federal Reserve kept rates on hold and shortly before the European Central Bank left rates unchanged too, the MPC said it would continue to monitor closely the situation in the Middle East.

Sterling weakened slightly against the U.S. dollar and the euro. Two-year British government bond yields , which are sensitive to speculation about BoE rates, fell by around 5 basis points and investors dialled back on their bets on three BoE rate hikes this year.

The 8-1 vote suggested the MPC lacked a clear plan of how to tackle the economic impact of the conflict, Matt Swannell, chief economic adviser to the ITEM Club, a forecaster, said.

"The prospect of rising inflation and a deteriorating labour market leave the Committee with a headache that they need more time to work out the remedy for," he said.

BoE Governor Andrew Bailey said the central bank would face a "difficult judgement call" on whether to raise rates, as waiting for conclusive evidence would leave things too late.

The governor said he did not want to push back against market expectations for at least two rate rises this year, but equally that his message today should not be read as "a slightly clandestine message that interest rates are going to go up".

On April 1, Bailey told Reuters that investors were being premature with their bets on multiple rate hikes this year.

DEEP UNCERTAINTY OVER LENGTH OF IRAN WAR

Faced with deep uncertainty about the duration of the war and the extent of the economic damage it will cause, the BoE opted not to publish a central forecast for inflation and other key economic indicators.

Instead, it produced three scenarios based on energy prices and different degrees of second-round effects. Under the most damaging Scenario C, where energy prices stay high for a prolonged period, inflation could peak at 6.2% in early 2027 - almost double its most recent reading - and stay above the BoE's 2% target for the coming three years, based on current market expectations for rates.

If that risk materialised, it was "likely to warrant a forceful tightening in monetary policy," the BoE said.

However, Scenarios A and B would require a "less restrictive policy stance" with the rise in market-based interest rates since the start of the war helping to offset inflation pressure. Governor Andrew Bailey said he placed most probability on Scenario B "albeit with slightly reduced second-round effects", but he also placed "some weight" on Scenario C.

Bailey told reporters the fact that the BoE had not cut interest rates, as expected shortly before the war broke out, provided "a good deal of space" to absorb inflation pressure.

While the BoE was on an "active" hold on rates, rather than a passive stance, the central bank was not sending a message that higher borrowing costs are coming, Bailey said. Around half the other members of the MPC who voted to keep rates on hold also said they put most weight on Scenario B. The scenarios were based on market pricing in the 15 days to April 22 and did not incorporate a further spike this week in global oil prices which hit a fresh four-year high on Thursday.

ACT EARLY OR WAIT FOR EVIDENCE?

The BoE said in minutes of the decision that some MPC members "might prefer to act early" to stave off the risk of inflation getting stuck too high while others could prefer waiting for more evidence of that risk crystallising.

The MPC said that while there was a risk of "material second-round effects" from the energy price shock - such as demands for higher pay or companies raising prices rather than absorbing higher costs - the jobs market was weakening and a rise in financial market borrowing costs would limit inflation.

"The Committee stands ready to act as necessary," it said in a statement, repeating language it used after its previous meeting in March.

Investors view Britain as highly vulnerable to the jump in energy prices due to the country's heavy use of natural gas.

Data published last week showed a rise in input costs for firms and companies raising their expectations for price increases in the 12 months ahead at a record pace.

But there are also concerns about a sharp hit to economic growth caused by the war.

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(Additional reporting by Sarah Young, Sam Tobin and Sam Tabahriti; Writing by William Schomberg; Editing by Toby Chopra)