Britain's high inflation rate unexpectedly fell, prompting investors to raise bets on the Bank of England pausing its long run of interest rates hikes as soon as Thursday.

Official data showed the consumer price index dropped to 6.7% in August, its lowest since February 2022, from July's 6.8%, confounding forecasts by economists polled by Reuters - and the BoE - for an increase.

Sterling sank by half a cent to its lowest against the U.S. dollar since May and it also fell against the euro as underlying measures of inflation weakened sharply.

Investors put a nearly 50-50 chance on the BoE keeping rates on hold on Thursday after 14 back-to-back increases stretching back to December 2021.

The Office for National Statistics said the slowdown in inflation was driven by a drop in often-volatile hotel prices and air fares, and by food prices rising less than a year ago.

That offset a jump in global fuel prices and an increase in a tax on alcoholic drinks.

Investors had been overwhelmingly expecting the BoE to raise interest rates again on Thursday, taking Bank Rate to 5.5% from 5.25%, even as signs of a slowdown in Britain's economy mount.

That looked less certain after the inflation data.

At 0800 GMT, investors put a roughly 45% chance on the BoE pausing its run of rate hikes at its September meeting, up from about 20% on Tuesday.

INFLATION PRESSURES AHEAD

"Thursday's Bank of England meeting just got a lot more interesting," James Smith, an economist at ING, said. "It's a very close call, but we’re still tempted to say the Bank will follow through with a hike tomorrow."

He said the expected increase was likely to be the BoE's last for now.

Yael  Selfin, chief economist at KPMG UK, said oil's recent price jump and potential pressures on food prices would weigh on the BoE.

"These could not only slow the disinflation process further but also reverse the decline in inflation expectations, causing further worry for the Bank of England," she said.

Last week, the European Central Bank raised rates to a record high but signalled that it was likely to pause. The U.S Federal Reserve is expected to keep rates on hold on Wednesday.

British inflation remains high - topped only by Austria and Iceland among Western European countries in August.

The Organisation for Economic Co-operation and Development said on Tuesday that Britain remained on course to have the highest inflation of leading rich economies in 2023.

But Wednesday's data showed core inflation - which strips out volatile food and energy prices - fell unexpectedly sharply to 6.2% from 6.9% in July.

Service sector inflation - closely watched by the BoE - lost some of its steam too, slowing to 6.8% from 7.4% in July.

There was further encouraging news for the BoE as separate data showed pay deals lost more of their inflationary heat.

As well as a relief to the BoE, which came under criticism when inflation surpassed 11% last October, the latest figures were welcomed by the government of Prime Minister Rishi Sunak. He has promised to halve inflation this year before an election expected in 2024.

"Today's news shows the plan to deal with inflation is working - plain and simple," finance minister Jeremy Hunt said.

"But it is still too high which is why it is all the more important to stick to our plan to halve it so we can ease the pressure on families and businesses."

He said Britain could not afford to go on a "borrowing binge," in a swipe at the opposition Labour Party which is riding high in opinion polls.

There were signs of a further weakening of inflation pressure ahead as factory gate prices fell 0.4% in the 12 months to August. Manufacturers' input prices dropped by 2.3%.

(Additional reporting by William James; graphic by Sumanta Sen; editing by Hugh Lawson and Bernadette Baum)