Sterling moves towards recent highs after inflation reading

LONDON (Reuters) - Sterling traded near a one-month high against the dollar and a 20-month high versus the euro on Wednesday after traders said a dip in September inflation was unlikely to stop the Bank of England from raising interest rates soon.

Consumer prices rose 3.1% in annual terms in September, easing back from 3.2% in August, official data showed. A Reuters poll of economists had pointed to inflation of 3.2% in September, although 11 of the 34 analysts polled predicted a slowdown.

But with the Bank of England expecting inflation to surpass 4% by year-end and many economists forecasting even higher rates in 2022 after a surge in energy prices and rising pressures in the food sector, investors still see policymakers hiking soon, possibly as early as next month.

The pound fell in mid-European trading but was back at $1.3823 by 1530 GMT, up 0.2% on the day and close to a one-month high of $1.3834 reached on Tuesday.

Against the euro, the British currency was up 0.1% at 84.25 pence, almost matching the 84.24 pence level reached on Tuesday that marked sterling's strongest since February 2020.

"A 15 basis points hike in November would seem about right because it gives the MPC (Monetary Policy Committee) cover on both ends -- signalling seriousness about inflation without signalling a willingness to crush demand in the process," said Stephen Gallo and Greg Anderson, FX strategists at BMO Capital Markets.

They said economic data on the health of demand in the UK economy would take on more importance between now and the Nov. 4 BoE meeting.

"As a result, we expect GBPUSD gains to encounter headwinds in the $1.3850/$1.3950 range, and we think EURGBP is a more attractive 'sell' in the 0.8500/0.8550 range," they added.

Some analysts believe money market traders are pricing in too much BoE tightening -- markets expect a cumulative 90 basis points of hikes by September 2022 -- leaving the pound vulnerable to a batch of weak data.

"Even before this inflation release this morning we were arguing that the forward OIS (overnight index swaps) market was indicating an excessive degree of monetary tightening priced into the markets," said MUFG analyst Derek Halpenny.

Although sterling has rallied in recent weeks, it has not moved as fast as might have been expected, given the change in rate expectations.

That is because of concern the UK economy is exposed to tighter policy as it emerges from the pandemic, and as Brexit-related supply chain shortages and relatively high rates of COVID-19 cases keep traders cautious about the outlook.

Graphic: World FX rates in 2020 http://fingfx.thomsonreuters.com/gfx/rngs/GLOBAL-CURRENCIES-PERFORMANCE/0100301V041/index.html

Graphic: Trade-weighted sterling since Brexit vote http://fingfx.thomsonreuters.com/gfx/rngs/BRITAIN-STERLING/0100310M299/index.html

(Reporting by Tommy Wilkes; Editing by Krishna Chandra Eluri and Bernadette Baum)