Sterling rallies after UK inflation beats expectations

By Jemima Kelly

LONDON, Aug 18 (Reuters) - Sterling rose towards a 7-1/2-year high on a trade-weighted basis on Tuesday after UK inflation data beat expectations, bolstering bets that the Bank of England will raise interest rates in the coming months.

The numbers showed consumer price inflation ticked up 0.1 percent in July year-on-year after slipping back to zero in June, beating expectations that it would remain at zero, while core inflation hit a five-month peak.

Traders must wait until Wednesday for further clues on when the BoE (Shenzhen: 200725.SZ - news) 's U.S (Other OTC: UBGXF - news) . counterpart, the Federal Reserve, might hike rates, when U.S. inflation data and Fed minutes are released.

Markets are currently expecting the Fed to move in either September or December, while they do not expect the BoE to raise rates until around March next year.

"We have a substantial gap between UK and the U.S. rate expectations, so the question is: is this gap in rate expectations justified or not?" said Morgan Stanley (Xetra: 885836 - news) 's global head of FX strategy Hans Redeker.

"Today's numbers are indicating that the gap is too wide, therefore sterling is going up."

Sterling rose 0.6 percent to hit an intraday high of $1.5676 after the data, having traded around $1.5594 before its release. Versus the euro, the pound gained 0.7 percent to 70.62 pence.

Against the BoE's trade-weighted basket of currencies, the pound rose to 94.5, its highest since August 6 and close to a 7-1/2-year high of 94.7 hit earlier in the month.

In its latest economic outlook, the BoE stressed that inflation would remain subdued until at least the middle of 2016 and said the impact of the rise in sterling could persist even longer.

But BoE rate-setter Kristin Forbes said on Sunday that interest rates would need to rise long before inflation hits the BoE's 2 percent target. Leaving them low for too long, she said, would risk undermining Britain's economic recovery.

Still, even if inflation does pick up in the coming months and if wages continue to grow strongly, many reckon the BoE would not risk hiking rates before the Fed.

"There's a pretty compelling case for an early rate hike in the UK where there's more wage growth than in the U.S., but there's also a sense - based on no evidence that I can see - that the MPC (KOSDAQ: 050540.KQ - news) would rather follow than lead the Fed," wrote Societe Generale (Swiss: 519928.SW - news) analysts in a research note. (Reporting by Jemima Kelly; Additional reporting by Sudip Kar-Gupta and John Geddie; Editing by Anirban Nag and Raissa Kasolowsky)