By Anooja Debnath
LONDON (Reuters) - Sterling hit a two-month low against the dollar on Friday after Britain's finance ministry said it would use revenue from the Bank of England bond-buying programme to reduce short-term debt issuance.
BoE Governor Mervyn King said the move equated to modest monetary loosening. This caught markets off guard and saw the pound slide 0.5 percent to $1.5903, its lowest since September 6.
Analysts said the announcement may reverse the benefit to sterling from the BoE opting on Thursday to leave its QE total unchanged.
The pound pulled well away from a five-week high against the euro which was hit after Thursday's decision.
"The transfer of the coupon payment from the BoE to the UK Treasury is not helping sterling, especially given that Mervyn King just described it as additional easing or QE," said Citi's head of European G10 currency strategy Valentin Marinov.
"That gilt coupon transfer, which looks very much like QE, could prompt investors who were long sterling to square some of the positions and add to the headwinds for sterling."
King said he had told the BoE's Monetary Policy Committee of the government's plans before they made the decision on Thursday not to pump any more cash into the economy.
The euro rose 0.2 percent to 79.92 pence as it recovered from Thursday's low of 79.605 pence.
After Friday's tweaks to the BoE's QE programme analysts said markets will scrutinise the BoE's Inflation Report on Wednesday next week for more clues on future policy moves.
"This (move) is sterling negative. It is unusual and is going to create uncertainty around policy," said Jane Foley, senior currency strategist at Rabobank.
"There are various questions that come to the market's mind as a consequence to this. Will there be more of this? Is this the new policy? This also questions the BoE's independence and credibility and King will have to answer those questions next week."
The BoE will release its latest growth and inflation projections in Wednesday's report.
Some analysts said Friday's announcement could mean the BoE is more downbeat on the economy than had been previously expected.
"The fact that the BoE are announcing additional easing (just before the Inflation Report) could indicate that it is concerned about the UK outlook for growth which subsequently could undermine sterling sentiment," Citi's Marinov said.
The pound was also hurt by worries about the euro zone growth outlook and the potential U.S. 'fiscal cliff', which threatens to tip the world's biggest economy into a renewed recession, prompting safe-haven flows into the dollar.
"It's going to be hard for sterling to make any significant gains against the dollar while there are worries about the U.S. fiscal cliff looming. Risk-seeking sentiment at the moment is generally not that buoyant," said Melinda Burgess, FX strategist at RBS.
But some market players saw scope for the pound to continue to benefit against the euro if worries about a deepening euro zone recession and uncertainties surrounding Greek and Spanish bailouts continue.
(Editing by Keiron Henderson)