(Updates prices)

By Joice Alves and Amanda Cooper

LONDON, March 21 (Reuters) - The pound fell, while UK

government bond prices rallied on Thursday after the Bank of

England kept interest rates unchanged but sigalled the economy

was moving in the right direction for it to start cutting rates.

The BoE kept its benchmark rate at 5.25% - its highest since

2008 - as had been widely expected, a day after data showed

inflation fell to its lowest in almost two-and-a-half years but

stayed too high for comfort.

Sterling fell by as much as 0.48% to a session low

of $1.2726 after the decision, from around $1.275 earlier on. It

is still on course for a 1% rise against the dollar this month.

Against the euro, the pound was down 0.3% at 85.63,

from around 85.55 earlier.

Two-year gilt yields, the most sensitive to

shifts in rate expectations, dropped by as much as 12.8 basis

points to the day's low at 4.103%, as prices rallied.

The BoE's interest rate-setters voted 8-1 to keep borrowing

costs at their 16-year high of 5.25% on Thursday as the two

officials who had previously called for higher rates changed

their stance.

"That's what really caught my eye - the two hikes last

meeting have turned more neutral and looking to keep rates on

hold," Fiona Cincotta, a market strategist for City Index, said.

"Overall that must make for a less hawkish position from the

central bank. And you can see the ship is turning towards that

rate cut and that is what the pound has grasped on to," she

said.

Britain's headline inflation rate, which topped 11% in

October 2022, fell by a bit more than expected to 3.4% in

February from 4.0% in January but was still the highest in the

Group of Seven.

Stubborn inflation in the UK has supported sterling this

year. The pound is one of the best performers so far, driven by

the expectation that other major central banks will start

cutting rates before the BoE.

After the BoE decision, money markets were pricing a 75%

chance of a rate cut in June, up from closer to 65% earlier in

the day.

Also on Thursday, the Swiss National Bank delivered a

surprise quarter-point cut, making it the first major central

bank to dial back tighter monetary policy aimed at tackling

inflation, while Norges Bank kept its rate unchanged.

The Bank of Japan ditched on Tuesday negative interest rates

and raised rates for the first time in 17 years, while on

Wednesday the Federal Reserve indicated it remained on course to

cut rates three times this year but stayed on alert about the

path of price growth ahead.

Separately, a survey on Thursdsay showed British businesses

kept up their recovery from recession this month, while

inflationary pressures showed no sign of rapidly abating,

potentially complicating matters for the BoE.