By Amanda Cooper
LONDON (Reuters - The pound seesawed on Wednesday, initially jumping after data showed UK inflation accelerated more than expected in May, then reversing gains, as concerns flared over the Bank of England's ability to protect the economy from stagnating.
Sterling was up 0.1% on the day against the dollar at $1.281, having traded as high as $1.2803 right after the data. Against the euro, the pound was up 0.2% at 85.35 pence, compared with 85.50 pence right before the numbers.
Official data showed consumer inflation rose by 8.7% year on year in May, showing no change from April's 8.7% rate, but above expectations for an increase of 8.4%.
But the core rate, which excludes food, energy, alcohol and tobacco, rose by 7.1%, above expectations for a reading of 6.8%, keeping the BoE under pressure to deliver a big rate rise when it meets later this week, but not so large it tilts the economy into recession.
"If you look at this in context, with the labour market and average earnings increasing 7.2% in April when core CPI was 6.8%, you've now got core CPI in at 7.1% - you're only going to see earnings increase further still and that's when you start to get those second- and third-round effects and that really gets embedded in the economy," TraderX strategist Michael Brown said.
Two-year gilt yields, the most sensitive to shifts in expectations for interest rates and inflation, shot above 5% for the first time in at least 15 years this week, reviving memories of the market crisis in September triggered by former Prime Minister Liz Truss' borrowing plans.
In theory, this creates an incentive for non-UK investors to buy sterling-denominated assets, in exchange for higher returns. But with inflation now looking increasingly entrenched and the central bank with limited scope to raise rates to quell it, that trade could lose momentum.
"A big chunk of sterling strength over the last couple of weeks has been the carry/rates story, a hawkish repricing in gilts going to their highest since 2007/8 ... it's not a 'positive higher rates' story," Brown said.
The BoE is expected to raise interest rates by 25 basis points to 4.75% on Thursday, but after the inflation data, money markets showed traders are placing an almost-50% chance of a half-point rise, up from 25% earlier in the day.