Sterling suffers a setback as U.S. inflation lifts dollar

(adds gilts, updates levels)

LONDON, May 22 (Reuters) - Sterling was on track for its biggest fall against the dollar in three weeks on Friday after a stronger-than-expected rise in U.S. core consumer prices in April revived bets that inflation may reach the Federal Reserve's 2 percent target.

If the upturn continues, it could allow the Fed to consider raising interest rates later this year, providing a boost to the dollar.

Sterling fell 1.1 percent against the dollar to $1.5497, well off a five-month high of $1.5815 struck on May 14. It was also 0.2 percent lower against the euro, trading at 71.10 pence, not far from a two-month high of 70.90 earlier in the day.

"The U.S. core inflation data has put a strong bid under the dollar," said a London-based spot trader. "Sterling and euro have come under pressure as a result."

Earlier, sterling hovered near a 7-year high against a trade-weighted basket of currencies, buoyed by robust data that bolstered a view that the British economy was outperforming its peers.

Britain's public sector budget deficit narrowed more than anticipated in April, data on Friday showed. Public sector net borrowing, excluding state-controlled banks, totalled 6.8 billion pounds last month, down nearly 27 percent from a year earlier and the lowest shortfall for that month since 2008.

Economists taking part in a Reuters poll had forecast a shortfall of 8.1 billion pounds.

Sterling bulls emerged on Thursday after data showed British retail sales rose more strongly than anticipated in April. The currency had taken a knock earlier this week after UK inflation fell below zero in April for the first time in 55 years.

"Aside from inflation risks, the UK economic outlook is extremely bright and this is very attractive to traders," said Jameel Ahmad, chief market strategist at FXTM.

"There were concerns that the UK economic revival was at risk of being over reliant on its housing sector. But consumers are now driving the UK recovery in different ways with the combination of low inflation and rising wages providing a boost to retailers."

Bank of England Deputy Governor Minouche Shafik said on Friday she saw "encouraging" signs from wage and labour market data, and that the causes of Britain's plunging inflation rate were not expected to last long.

And, Governor Mark Carney reiterated in a speech that interest rates increases, when they happen, would be gradual.

British government bond prices rose moderately, in step with German Bunds, as the market focused again on central banks' continued use of heavy stimulus.

At 1437 GMT the 10-year gilt yield was down around 4 basis points on the day 1.94 percent. (Reporting by Anirban Nag and Andy Bruce; Editing by Mark Heinrich)