The pound strengthened to $1.64 for the first time since January 2010 and gilts slumped as U.K. inflation accelerated more than economists forecast, fuelling speculation that the Bank of England will raise interest rates in the coming months. Sterling appreciated the most in a month versus the euro yesterday, while gilt yields jumped to the highest in a week.

Consumer prices rose 4.4 percent in February from a year earlier, according to the Office for National Statistics, higher than the 4.2 percent median forecast of economists in a Bloomberg News survey. Separate data also showed Britain’s budget deficit unexpectedly widened.

The pound rose 0.5 percent to $1.6387 as of 4:18 p.m. in London and earlier reached $1.6401, the strongest level since Jan. 19, 2010. Against the euro, sterling strengthened 0.7 percent to 86.64 pence. The yield on 10-year gilts rose eight basis points to 3.60 percent. The 3.75 percent bond due September 2020 fell 0.6, or 6 pounds per 1,000-pound ($1,625). Short-sterling futures fell, sending the yield on the contract expiring in December up nine basis points to 1.48 percent, as traders increased bets on a rate increase.

U.K. inflation is running at its fastest pace since October 2008 and has held above the central bank’s 2 percent target for 15 months. Commodity prices have surged and the pound’s 25 percent drop on a trade-weighted basis since the start of 2007 has boosted import costs. Bank officials were split at February’s policy meeting on whether to raise borrowing costs to tame price pressures. Policy maker Andrew Sentance voted to raise the key interest rate a half point from a record low of 0.5 percent. His colleagues Spencer Dale and Martin Weale and favoured a quarter-point increase, and the remaining six members of the MPC voted for no change.

The Pound continues to remain stable against the higher yeilding currencies, although slightly down on the day – The Australian Dollar was supported yesterday by firmer commodity prices and a return to risk after last week’s co-ordinated G7 intervention to curtail the surging Japanese Yen. In the absence of any local economic data for the entire week, moves to the upside are expected to be limited as investors are keeping a close eye on developments in Libya, Bahrain and Yemen. There are renewed concerns that anti-government protests may spread to other Arab countries, disrupting oil supplies and reducing demand for assets and currencies linked to growth such as the Aussie.

The Euro touched fresh five-month highs against the greenback overnight at 1.4247 after an ECB board member reiterated that “strong vigilance” is required to keep a lid on inflation. However, the 17-nation currency was sold down to a low of 1.4175 as investor concern re-surfaced that European Union leaders will struggle to find a permanent solution to region’s debt crisis. The renewed fears come amid rising yields on Irish government debt securities and speculation that Portugal may ask for EU assistance as early as tomorrow if they are unable to proceed with proposed budget cuts.

Looking ahead, the key event risk for the day comes in the form of the Bank of England Minutes due at 9:30GMT. While the central bank remained on hold at the previous rate decision and doves still retained control, there has definitely been a notable shift in favor of the hawks. The previous Minutes revealed a 6-3 split, with Spencer Dale joining on the hawkish side and voting for a rate hike along with Martin Weale and Andrew Sentance.

The UK’s Chancellor George Osborne also presents the 2011-12 Budget later today. Although some of the headline numbers were laid out in the Autumn Spending Review, markets will be watching closely for detailed explanations, as well as any updated economic forecasts moving forward.