By Jemima Kelly
LONDON (Reuters) - Sterling strengthened on Tuesday as data showed British inflation unexpectedly stayed close to its highest levels in six years in January, firming up investors' bets that the Bank of England will raise interest rates again in May.
The BoE surprised financial markets last week by indicating that rates could move up faster than previously expected, as the Bank wanted to bring inflation back to its target of 2 percent within two years rather than three.
This prompted markets to price in as much as a 70 percent chance of a quarter-point rise in interest rates by May, and a roughly 50 percent chance of a further increase in rates to 1 percent by the end of the year - a level last seen in 2009.
Tuesday's numbers showed consumer price inflation (CPI) held at an annual rate of 3.0 percent in January, unchanged from the month before and above a consensus forecast of 2.9 percent.
"This adds further weight to the case for higher interest rates sooner rather than later," wrote Hargreaves Lansdown (LON:HRGV) economist Ben Brettell in a note to clients.
"It seems domestically driven inflation could seamlessly take over from the sterling-related price rises we’ve seen since the Brexit vote. If this is the case, some tightening of monetary policy looks increasingly appropriate."
Sterling jumped to as high as $1.3924 <GBP=D3> after the data, up from $1.3886 beforehand. It was trading at $1.3906 by 1012 GMT, up half a percent on the day.
Against the euro, sterling strengthened by a third of a percent to 88.59 pence (EURGBP=D3).
The historic measure of retail price inflation (RPI), which is still used to calculate payments on government bonds, student loans and many commercial contracts, edged down to 4.0 percent from December's six-year high of 4.1 percent.
"It (the data) has not exactly blown the doors off," said Mizuho's head of hedge fund FX sales, Neil Jones.
"Some people were thinking the annual figure could actually come in above the 3 percent level, which is one of the reasons Cable (sterling/dollar) was catching a bid this morning."
The pound skidded to a three-week low against the dollar on Friday after the EU's chief Brexit negotiator Michel Barnier warned a transition deal was far from assured.
Those comments, as well as broad strength in the dollar amid a sharp stock market sell-off, handed sterling its biggest weekly falls since October, as investors worried that Britain could leave the European Union in a disorderly manner.
Analysts said British wages data due next week, as well as a major upcoming speech by the prime minister on Brexit, would be the next determinants of sterling's direction.