Official figures from the Office for National Statistics showed UK inflation rose to 9%, the highest level in 40 years, indicating the Bank of England could be forced to take a more dovish stance when hiking rates.
The latest gauge falls in line with BoE predictions. The central bank forecast inflation to rise as high as 10% this year, warning this could tip the economy into recession. Analyses by think tanks already point to UK's poorest households facing nearly 11% inflation.
It comes as economic activity slowed sharply during the first quarter of 2022, with the UK economy suffering its worst bout of stagflation – weak growth alongside high inflation.
"With the spectre of stagflation looming, there are expectations that the Bank may be forced to take more of a softly-softly approach," said Susannah Streeter, senior investment and markets analyst at Hargreaves Lansdown.
Wednesday's drop reverses most of the gains the pound made the day before when it touched its highest level since 5 May, having jumped 1.4% after data showed the unemployment rate had dropped to its lowest since 1984.
Danni Hewson, financial analyst at AJ Bell, said: "The pound’s taken a pummelling as UK inflation soars to a 40-year high suggesting the British consumer will be forced to reign back even harder, dragging the economy as a whole further towards that recession cliff edge.
"Yesterday’s jobs figures suggested the Bank of England might have quite a bit of wiggle room when it came to rate rises but considering how hot prices are running already there’s real concern that any further moves it makes will only serve to cut back consumer spend and business investment.
"The fact the UK has shot past US inflation numbers is just adding to the mix, strengthening the dollar as investors consider the Fed is in a stronger position to hike rates faster and higher than its UK counterpart.
"It’s all a balancing act but one that’s leaving many households teetering on the brink of real hardship and there’s expectation the UK government will have to loosen its purse strings to help people through the next difficult months."
Brexit-related risks around changes to the Northern Ireland protocol and the potential for a trade war with the European Union is another major downside risk for sterling, according to analysts at ING, who expect it to trade at mostly below $1.2500 versus the dollar during the summer.
"The oversold pound has faced a strong rebound this week, recouping some of its recent sharp losses as global risk appetite improved," ING said. "While the good GBP momentum may continue as equities find some stability in the coming days."