By Samuel Indyk
LONDON, Aug 17 (Reuters) - The British pound weakened on Wednesday as data showed inflation climbed to its highest level in more than four decades in July, heaping pressure on the Bank of England to bring down prices but increasing the risk of a sharper economic slowdown.
Consumer price inflation rose to 10.1% in July, its highest since February 1982, official figures showed. A Reuters poll showed economists had expected inflation to rise to 9.8%.
Higher-than-forecast inflation supports the view that the Bank of England (BoE) will follow up last month's 50 basis point rate rise with a second consecutive half-point increase in September.
Money markets are now fully pricing in a 50-bps rate rise from the central bank next month, with outside chances of a larger 75-bps hike, according to data from Refinitiv.
Traders are now also pricing in a further 200 bps of tightening by May, taking the Bank Rate to 3.75%. Prior to labour market data on Tuesday, traders expected interest rates to peak in March with a further 150 bps of tightening, Refinitiv data showed.
Even with inflation running at its highest level in decades, analysts said the outlook for the pound remained bleak as front-loading rate rises increased the risk of a hard landing for the economy.
"Sterling is highly correlated to UK recession risks right now," said Viraj Patel, global macro strategist at Vanda Research, who said that Wednesday's data is likely to lead to faster, front-loaded tightening from the BoE.
"Today's CPI print reinforces the stagflationary risks in the UK. You wouldn't necessarily want to be holding a risky currency like sterling into a recession."
At 1428 GMT, the pound was down 0.24% against the dollar at $1.2069.
Against the euro, sterling was down 0.35% at 84.35 pence, after earlier touching its strongest level against the single currency since Aug. 4 at 83.90 pence.
British two-year government bond yields surged to their highest since November 2008 following the data.
The gap between 2-year and 10-year gilt yields - sometimes viewed as a signal of recession - was at its most inverted or negative on record at around minus 17 bps, according to Refinitiv data going back to late 2010.
Longer-dated yields are typically higher than shorter-dated yields because investors demand a premium to compensate for the risk of buying bonds that mature years later.
The BoE said this month it expected inflation to peak at 13.3% in the fourth quarter, due mostly to the surge in energy prices. The central bank also forecast a five-quarter-long recession, beginning at the end of this year.
(Reporting by Samuel Indyk, additional reporting by Tommy Reggiori Wilkes; Editing by Robert Birsel, Devika Syamnath and Nick Macfie)