LONDON (Reuters) - The Bank of England (BoE) expects inflation to fall below target in two years, but a highly uncertain economic outlook makes it unclear whether the central bank's next move will be to loosen or tighten policy.

Sterling rose sharply and British government bond futures dropped, suggesting investors think it is now less likely the central bank will follow the US Federal Reserve in injecting more stimulus into the economy.

However, the BoE's quarterly Inflation Report on Wednesday did leave the door open to more quantitative easing — buying assets with newly-created money — and the central bank said it stood ready to act in either direction.

"The committee is still relaxed over the inflation outlook but is not sufficiently concerned over economic prospects to sanction a further round of QE", said Philip Shaw, chief economist at Investec.

Governor Mervyn King said there was "vigorous debate" and a wider than usual range of views over the risks to inflation and growth among Monetary Policy Committee members.

"We cannot be sure which of the big risks to the outlook will materialise," King told reporters, arguing that the economic recovery depended heavily on stronger demand across the world, because domestic spending in Britain was likely to slow.

"Given the scale of the fall during the recession, the level of output is likely to remain weak," he said.

Britain's economy has rebounded strongly from an 18-month recession, posting its strongest six-month period of growth for a decade in the middle of this year, but government spending cuts and tax rises are expected to weigh on activity next year.

Meanwhile inflation has remained higher this year than the BoE anticipated.

The government wants the BoE to support growth while it tackles a record budget deficit. While the central bank sees CPI at around 1.6 percent in two years' time, assuming interest rates rise slowly as markets expect, forecasts show it remaining well above the two percent target in 2011.

As such, policymakers have to balance concerns about weak growth against several factors driving prices higher.

The BoE's inflation forecast was slightly higher than the August projection and the near-term inflation profile has also been revised higher due to higher import costs and a planned increase in value added tax (VAT).

"As the impact of those factors on inflation diminishes, inflation is likely to fall back, reflecting continued downward pressure from the persistent margin of spare capacity," the BoE said in its report.

"But the timing and extent of that decline in inflation are highly uncertain."

Minutes of the BoE's last meeting — when it kept interest rates at a record low of 0.5 percent and froze its £200 billion QE plan — will be published next Wednesday. That could give a better idea of where the MPC's policy bias lies.

Policymakers were split three ways in October, with one voting for higher rates, one arguing for more QE and the remaining seven favouring keeping policy on hold.

The BoE said economic growth would slow in 2011 but then pick up to just over three percent in two years' time.

These forecasts were also highly uncertain, however. Exports had still not picked up as the BoE expected and, while domestic demand could grow rapidly if confidence recovers, there were also significant downside risks — not least from the government's austerity measures.