Sterling recovers from sharp falls but remains vulnerable
* Sterling pulls away from 2-1/2 year low versus dollar
* Analysts say sterling still vulnerable to easing prospects
* Weak UK economy, risk of ratings downgrade also weigh
* Could consolidate in very short term
LONDON, Feb 22 (Reuters) - Sterling pulled away from a two-and-a-half year low against the dollar and rose against the euro on Friday as investors bought it back after sharp falls, though it remained vulnerable to renewed selling.
Analysts and traders said the pound had scope for a slight recovery as investors who had previously sold the currency picked it up at lower levels. So far this year sterling has lost as much as 8 percent against the euro and almost 7 percent against the dollar.
But they expected market players would soon resume selling since Bank of England minutes on Wednesday showed policymakers edging closer towards more monetary easing. This came after the BoE's quarterly report last week said policymakers were prepared to tolerate higher inflation as growth remains weak.
The pound was up 0.3 percent against the dollar at $1.5298, recovering after falling to as low as $1.5130 on Thursday, its weakest since mid-July 2010. But traders reported offers from $1.5320-50 that may cap any rise.
The euro was down 0.4 percent at 86.10 pence, well below a near 16-month high of 87.645 pence on Wednesday.
"The correction in euro/sterling could get down towards 85 pence, but I see this as a short-term respite and we could see a resumption of euro gains up towards 90 pence by the end of next month," said Chris Redfern, senior trader at Moneycorp.
"The central bank's focus seems to be all about wanting to devalue the pound."
BoE policymaker David Miles, who has recently voted to extend quantitative easing, said on Thursday there was a good case for restarting monetary stimulus. He said the central bank may need to buy up to 175 billion pounds more of government bonds if growth is far below potential.
The pound was helped by broad falls in the euro after the European Central Bank said banks would pay back 61.1 billion euros of the second of two crisis loans, less than half the amount expected by the market.
A report from the European Commission that forecast the euro zone economy would contract again in 2013 and caution ahead of an Italian election this weekend also weighed on the euro.
RISKS TO STERLING
Data on Thursday showing Britain's public finances posted a large surplus in January helped sterling to rebound, although concerns remained about whether the government can meet its targets for reducing the deficit.
But analysts and traders said Bank of England policy and the risk of a downgrade to the UK's triple-A sovereign rating left longer-term investors increasingly inclined to sell the pound.
Traders said investors were likely to take advantage of higher levels to resume selling, with many expecting the pound will soon drop to $1.50.
"When the UK has a central bank that has turned its back on an inflation target and at the same time there is the potential for it to do more quantitative easing, long-term investors are questioning whether this is a good place to hold their money," said Simon Smith, economist at FXPro.
"In the very short term, sterling could see a bit of a correction but thereafter it will push towards $1.50 and could be around the $1.45 area by mid-year."
Morgan Stanley told clients they retain a "fundamental bearish view" on sterling but see the possibility of a retracement that could push it as high as $1.55. They will therefore wait before they resume selling the currency.