Bank of England governor Mervyn King yesterday left the door wide open for another rise in UK interest rates when he and his Monetary Policy Committee colleagues testified before the Treasury Select Committee.

King hammered home his view that the risks to inflation two years out remained to the "upside". He said the MPC was "concerned about" UK firms' surprisingly high confidence about pushing through price rises.

King also noted the UK All-Share index had "all but regained its level prior to the onset of the turbulence" in world financial markets which began at the end of February, having fallen by around 5% at one stage.

However, he added: "It is too early to say whether the period of greater volatility is over."

Meanwhile, citing the rise in inflation expectations in financial markets in the last year, he declared: "That is not a welcome development."

He also gave his view that the surprise fall in annual UK consumer prices index inflation from 3% in December to 2.7% in January had been "largely offset by the subsequent unexpected pick-up to 2.8% in February" - perhaps signalling a hawkish frame of mind.

King also, although citing expectations of a sharp fall in inflation this year as household electricity and gas prices tumbled from their peaks, declared: "The challenge facing the MPC is to look through those short-term fluctuations."

The nine-strong MPC forecast, in its February inflation report, that annual CPI inflation would be around the 2% target set by Chancellor Gordon Brown on the key two-year time horizon. This was based on market interest rates, which were at that stage pricing in one more quarter-point rise in UK base rates from their current 5.25%.

King told the Treasury Select Committee yesterday: "In February, the judgment of the committee was that the central projection for CPI inflation some two years ahead was around the 2% target, but with the risks to the upside. The balance of the news since then provides no clear reason to change that judgment."

This indicates that the fact that the minority vote switched from being for a rate rise in February to favouring a cut in March might be a red herring in terms of the outlook.

The MPC has raised UK base rates three times this cycle, last August and November and this January, with no change in the latest two months.

Most economists are predicting one more quarter-point rise, with May viewed as the most likely month for this.

Survey evidence has indicated companies are enjoying some success in raising prices, apparently restoring battered profit margins as energy prices fall. The MPC had last year expressed fears this might happen but the extent of it seems to have taken members by surprise.

King said: "There were other factors which led to a pick-up in inflation, which we hadn't anticipated. One thing we hadn't anticipated was a noticeable rise in the number of firms saying they expected increases in prices to stick. That's something we're concerned about."

External MPC member Kate Barker told the Treasury committee: "Price expectations, certainly in manufacturing, are relatively strong."

MPC members were, however, much more relaxed about wage inflation. Their big fear had appeared to be high CPI inflation would feed through to higher pay demands - triggering a wage-price spiral.

However, King said yesterday of wage deals: "Our general view is there doesn't seem to be very much change over the last year."

Gordon Brown has played a part in keeping down wage settlements - revealing earlier this month that he had kept the overall public sector award down to 1.9% even though annual inflation on the old all-items retail prices index measure still used in private sector bargaining ended 2006 at a then 15-year high of 4.4%.

Bank of England deputy governor Sir John Gieve yesterday described the limit on public sector pay review bodies as "tough by anyone's standards".

King said there were "now some signs that the housing market is beginning to slow".

His comments coincided with figures from the British Bankers' Association yesterday showing that the number of new loans approved for house purchase by the big UK banks came in at 54,659 in February - down nearly 5% on the 57,385 figure for the same month last year.

King emphasised the UK mortgage market was "not seeing the same default experience" as the US. The US sub-prime sector, which serves customers with poorer credit ratings, has come unstuck.

Referring to the UK, King said he did not think the consequences would be very severe if house prices were to fall by a "relatively modest amount". He added that the outcome would be much more severe if there was a very large fall, "which I don't think is very likely".

King described the slowdown in unsecured lending growth in the UK as "welcome", while emphasising he paid more attention to the potential impact on inflation from fast money supply growth than some MPC colleagues.

He also highlighted strong business investment growth.

National Statistics yesterday revised up the annual rate of business investment growth in the fourth quarter of 2006 from 11.1% to 13.5% - its highest for eight years. It said the 4.5% rise during the October to December period was the fastest quarterly rate of increase in three years.