BoE walks tightrope between inflation and recession, Bailey says

LONDON (Reuters) -Bank of England Governor Andrew Bailey said on Thursday the British central bank was walking a tight line between tackling inflation and avoiding recession, with the strength of the labour market a key question right now.

The BoE last month softened its language on the need for more interest rate increases as rate-setters stressed downside risks to the economy, in addition to existing worries about inflation becoming embedded in expectations.

"We are now walking a very tight line between tackling inflation and the output effects of the real income shock, and the risk that that could create a recession and pushes too far down in terms of inflation," Bailey said at an event organised by the Peterson Institute for International Economics in Washington.

Earlier on Thursday, BoE rate-setter Catherine Mann placed a greater emphasis on the need to prevent inflation expectations becoming embedded and said borrowing costs would probably have to rise further.

Consumer price inflation hit 7% in March and last month the government's budget watchdog predicted it will peak at nearly 9% later this year - several times the BoE's 2% target.

Bailey said he rejected any commentary that inflation targeting had failed.

"What it's now going through is its most severe test since it was created 20 to 25 years ago. So more than ever we need it," Bailey said.

The BoE has raised interest rates three times since December, more than any other big central bank, and markets expect it do so again at its next meeting in May.

Bailey said a key question was whether the labour market would slow down.

Official data last week showed Britain's unemployment rate fell recently to its joint lowest in almost 50 years, but earnings shrank by the most since 2013 in February when adjusted for surging inflation.

British businesses were experiencing widespread recruitment problems, Bailey said.

"We have to ask ourselves the question, well: is that going to cause the labour market to be stronger for longer, notwithstanding a decline in growth? Because there may well come a point where people decide they're going to hoard labour."

(Reporting by David Milliken Writing by William Schomberg and Andy BruceEditing by Jonathan Oatis)