Sterling rallies as dollar sellers emerge, UK growth beats forecasts

LONDON (Reuters) -The British pound rose on Wednesday, helped by a broadly weaker dollar and after data showed the UK economy grew unexpectedly in May.

Economic output expanded by 0.5% in May, although consumer services fell as the surge in inflation hit shoppers. A Reuters poll of economists had pointed to zero growth in May from April.

The pound's fortunes on Wednesday were largely tied to moves in the dollar, however, with sterling weakening to as low as $1.1828 - near a two-year low - shortly after forecast-beating U.S. inflation data was released.

The dollar then began falling sharply as traders betting on a higher U.S. currency took profits.

By 1456 GMT, sterling was up 0.6% at the day's high of $1.1968.

Against the euro it fell 0.3% to 84.61 pence , largely on the back of the euro rebounding across the board after dropping below the symbolically important level of $1.

The pound has fallen sharply against the dollar in 2022, hit mostly by the soaring dollar but also as investors worry about the health of the UK economy and political uncertainty following the resignation of British Prime Minister Boris Johnson.

The ruling Conservative Party is in the process of selecting a new leader to succeed Johnson.

Despite growth in May coming in better than expected, other indicators point to weakening economic momentum in Britain, making it even more difficult for the Bank of England as it tries to tackle inflation by increasing interest rates while at the same time not slowing the economy excessively.

"Given the scale of the slowdown and the softness in the forward-looking indicators, we do think that the recent growth data matters for the BoE," Morgan Stanley economist Bruna Skarica said, predicting a 25 basis points hike from the BoE when it meets on Aug. 4.

Investors will also be watching the Conservative party leadership race. The winner is to be announced in early September.

Most of the candidates to replace Johnson said they will cut taxes to get the economy growing again. Former finance minister Rishi Sunak, who is also in the race, said he wants to control inflation first.

(Reporting by Tommy Reggiori Wilkes; editing by Amy Caren Daniel and Mark Heinrich)