LONDON (Reuters) - Sterling equalled a 5-1/2 year high against a trade-weighted basket of currencies on Tuesday, helped by a rally to a 16-month peak against the euro after a report showed British inflation rose more than expected in April.
Britain's consumer prices index rose to an annual rate of 1.8 percent last month from 1.6 percent in March, according to the Office for National Statistics. Economists in a Reuters poll had expected the index to rise 1.7 percent.
The euro fell 0.35 percent to 81.19 pence, its lowest since early January 2013, from around 81.30 pence before the data were released. The gap between UK two-year gilt yields and euro zone two-year yields widened after the report, helping the pound, traders said.
In contrast with the rise in British inflation, the pressure of falling prices in the euro zone is pushing the European Central Bank towards looser monetary policy next month. It could also take the deposit rate - the rate at which banks deposit excess funds with the ECB - into negative territory, making it unattractive to buy euros.
"UK inflation is higher than expected and further improvement in labour market conditions mean in coming months the Bank of England cannot keep rates low for longer. So that is being reflected in sterling's rise," said Manuel Oliveri, FX strategist at Credit Agricole.
Sterling rose against the dollar to a day's high of $1.6870 after the data, from around $1.6850 before it was released. The currency was last trading at $1.6845, still up 0.2 percent on the day. The sterling trade-weighted index rose to 87, a level visited last week and its highest since Oct. 2008.
"The data fuels expectations for an early rate hike from the Bank of England; this despite the dovish tone of the Inflation Report last week," said Alex Edwards of UK Forex.
The inflation data gave a slight boost to expectations of an interest rate increase. The sterling overnight interbank average (SONIA) curve showed investors pricing in a slightly better chance of a rate rise in 10 months' time.
Such expectations were dampened last week after the Bank's quarterly inflation report and accompanying remarks by Governor Mark Carney suggested a rate increase may not happen quite as early as many had predicted.
The UK economic picture painted by recent data was still brighter than the outlook for the euro zone and the United States, analysts said, making the pound attractive whenever it retreats.
Morgan Stanley analysts have recommended that investors build short positions in the euro against the pound, targeting a drop to 80.50 pence.
Minutes from the Bank of England's monetary policy committee's latest meeting will be released on Wednesday. Sterling bulls are hoping that hawks such as Martin Weale could start voting to increase the Bank's base rate from record lows, helping to underpin the pound.
Reporting by Anirban Nag; Editing by Larry King and David Goodman