The August Inflation Report is much less dovish than the market expected and signals that the Monetary Policy Committee now has a neutral policy bias, following the £50 billion expansion of QE announced last week.

The mean inflation forecast based on an unchanged level of Bank rate is an estimated 2.1% and rising at the two-year horizon. This is up from 1.7% in May and a record low 0.4% in February, and the first above-target projection since August last year. The deviation from 2% is an indicator of policy bias and has often signalled rate moves – see chart.

This inflation view rests on a respectable economic recovery but the MPC's GDP forecasts are not particularly aggressive. Output rises by about 2% in the year to the second quarter of 2010 in the central case based on unchanged rates. Risks, however, are weighted to the downside, so the mean projection is only about 1.5%.

In addition to the two-year-ahead projection, the MPC has raised its shorter-term inflation forecasts, partly reflecting a less optimistic assumption about domestic energy prices (expected to fall by 5% during the second half versus 15% in the May Report). After an undershoot in the second half, inflation returns to about 2% in early 2010.

Bank of England Governor Mervyn King referred to the likelihood of having to write a letter to the Chancellor explaining a fall in inflation to below 1% later this year. However, the central-case and mean projections for the third and fourth quarters are above 1%, suggesting that any move below will last a single month (and would not have occurred without the VAT cut).

Echoing earlier remarks in a speech, Deputy Governor Bean referred to the option of achieving a future tightening of policy initially by raising Bank rate, with gilt sales staggered over a longer period and conditioned on market developments. The difficulties of reversing QE imply that rate rises, when they begin, could be rapid.