LONDON (Reuters) - Sterling hit a two-month low against the dollar on Monday, extending falls after the effect on monetary policy of last week's bond-buying changes and on caution before Wednesday's Bank of England Inflation Report.
The pound was down 0.15 percent at $1.5869, having hit $1.5865, its weakest since September 5.
It has been under selling pressure since the government unexpectedly announced on Friday it would use proceeds from the BoE's bond-buying programme to trim its short-term borrowing, a move BoE Governor Mervyn King said equated to a "moderate loosening" of policy.
"The implicit assumption is that this (Friday's announcement) is an easier monetary policy stance ... it plays along with the assumption that policy will have to remain loose because of the relative fragility of the economy," said Jeremy Stretch, head of currency strategy at CIBC.
"Investors will probably get nervous before the Inflation Report and will play sterling from the short side," he said, adding the pound could drop to the $1.5850-$1.5825 area.
The pound has chart support at the 200-day moving average at $1.5850. It has not been below its 200-day average since late August.
Markets will scrutinise the BoE's quarterly report on Wednesday, where the bank releases its latest growth and inflation projections, for indications on the outlook for the economy and the prospects of more easing in the future.
A string of UK data this week, including inflation figures on Tuesday, jobs figures on Wednesday and retail sales on Thursday, should give an indication of how the UK has begun the fourth quarter after solid growth in the third.
Concerns surrounding the looming U.S. fiscal cliff of tax hikes and spending cuts due to come into effect in January could also see safe-haven flows into the dollar and weigh on the pound, analysts said.
The euro rose 0.2 percent against sterling to 80.11 pence, although gains were limited due to uncertainty about Greece's ability to repay its debt.
"Today's (currency) move should be a follow-through of Friday's BoE measure," said Adam Cole, global head of FX strategy at RBC Capital Markets, adding sterling was likely come under pressure.
CMC Markets strategist Michael Hewson said a break through resistance around 80.30 pence, near the 50-day moving average, would open the door to a test of 80.75 pence, the October 31 high.
Wednesday's quarterly Inflation Report from the BoE will help investors assess the chances of further monetary easing via bond purchases, which could knock the pound as they increase the currency's supply.
Before that, data on Tuesday is expected to show the annual rate of consumer inflation rising slightly to 2.3 percent in October from 2.2 percent the previous month.
"Sterling should be soft ahead of the Inflation Report," said Chris Turner, head of FX strategy at ING.
"The experience is that although there are some concerns about inflation being sticky it is likely Mervyn King will try to press sterling (lower) somehow," he added, referring to expectations the BoE governor might paint a gloomy picture of the UK economy.
A weaker pound would make British exports more competitive, potentially helping to erode the country's trade deficit.
ING's Turner said the Inflation Report would likely forecast UK inflation to be below the 2 percent target in two years' time, indicating the BoE may keep monetary policy loose for some time.
He expected the pound to weaken to around $1.57 against the dollar by next month.
(Additional reporting by Jessica Mortimer; Editing by Toby Chopra)