June 17 (Bloomberg) -- The U.K. pound dropped the most in two weeks against the euro as traders pared bets the Bank of England will boost interest rates on speculation worsening inflation will stifle economic growth.

The currency also snapped two days of gains versus the dollar after a government report showed inflation last month reached the fastest pace in at least a decade, prompting central bank Governor Mervyn King to say the direction of interest rates is ``uncertain.'' Two-year government bonds rose the most in more than two months.

``There's nothing there that would suggest sterling strength,'' said Simon Derrick, chief currency strategist in London at Bank of New York Mellon Corp. The number ``is not quite enough to justify a trigger. The Bank of England is not really likely to jump either way at the moment.''

The pound dropped as much as 0.9 percent, the most since June 2, and was at 79.33 pence per euro at 6:01 p.m. in London, from 78.83 pence yesterday. The currency fell 0.3 percent to $1.9569, from $1.9632.

The pound may fall to 80 pence per euro in the next three months, Derrick said.

Consumer prices climbed 3.3 percent in May from a year earlier, the most since at least 1997, the Office for National Statistics said today in London. Economists in a Bloomberg News survey predicted a 3.2 percent advance. The increase legally compelled King to write a letter to Chancellor of the Exchequer Alistair Darling explaining why the rate strayed more than a percentage point from the 2 percent target.

`Above Target'

Inflation ``is likely to remain markedly above the target until well into 2009,'' King said in the letter, released by the central bank in London. ``The committee will maintain price stability by ensuring that the rise in inflation is temporary.''

The ``path of bank rate that will be necessary to meet the 2 percent target is uncertain,'' he wrote. The letter is the second to be written since the bank was made independent in 1997.

The U.K. currency has slumped 13 percent against the euro since Sept. 14, when the central bank provided emergency funding to Northern Rock Plc after the first run on a U.K. bank in more than a century. Inflation has since accelerated while growth has sputtered amid a slump in house prices.

Popularity Slump

The slowdown has contributed to a slide in the popularity of Prime Minister Gordon Brown's Labour government. Backing for the party slumped to its lowest level since surveys began, a YouGov Plc poll showed May 30.

King's letter today ``indicates that the kind of rate hikes needed to bring consumer inflation back to 2 percent on a two-year horizon are not going to be delivered,'' Marc Chandler, global head of currency strategy at Brown Brothers Harriman & Co. in New York, wrote in a client note. ``Knee-jerk gains were quickly unwound.''

The yield on the two-year U.K. gilt slid as much as 20 basis points, the most since March 31, and was at 5.37 percent. The price of the 4.75 percent security due June 2010 rose 0.37, or 3.7 pounds per 1,000-pound ($1,955) face amount, to 98.92. The 10-year yield dropped 8 basis points to 5.14 percent. Yields move inversely to bond prices.

The implied yield on the short-sterling futures contract due September dropped 16 basis points to 6.09 percent, the lowest since June 6, indicating investors are less confident rates will rise. The odds of the central bank lifting borrowing costs dropped to 9 percent from 15 percent yesterday, according to a Credit Suisse Group derivatives index.

Market Signal

The pound's losses ``could signal markets are shifting from single-minded focus on higher inflation and beginning to look toward the potentially deleterious impact of higher rates, inflation and slower growth,'' Citigroup Inc. analysts including Tom Fitzpatrick, New York-based global head of currency strategy, wrote in a client note.

U.K. notes increased with their European counterparts as investor confidence in Germany, the largest of the 15 nations that share the euro, dropped in June by more than forecast, reducing the chance that the European Central Bank will raise borrowing costs to combat inflation.

U.K. two-year notes yielded 21 basis points more than 10-year notes, reducing the so-called inverted yield curve to the least in almost a week. The phenomenon is an anomaly because investors typically demand higher yields for the risk of owning longer-dated securities than shorter-dated ones. The U.K.'s two year notes yielded 75 basis points more than equivalent German notes, from 84 basis points yesterday.

``There's an opportunity in the front end of the gilt market,'' David Keeble, head of fixed-income strategy in London at Calyon, the investment-banking unit of Credit Agricole SA, said in a Bloomberg television interview. ``The chances of rate hikes are very limited right now.''

To contact the reporter on this story: Lukanyo Mnyanda in London at lmnyanda@bloomberg.net

Last Updated: June 17, 2008 13:04 EDT