The pound rallied against a host of currencies today as Britain's plunge towards deflation was not as dramatic as feared.

Sterling overturned early losses against the US dollar and extended gains against the euro after the Consumer Prices Index dropped from 3.1% in December to 3% in January.

The Retail Prices Index, which includes housing costs, fell more dramatically, from 0.9% to a 49-year low of 0.1% as lower interest rates filtered through to mortgages.

The City was expecting CPI to fall to 2.7% and although economists still reckon the Bank of England will cut interest rates again next month, the pound found support.

“The number has come in a little higher than expected and that is the reason for the slight kick higher in sterling,” said James Hughes at CMC Markets.

The pound was up 0.28 of a cent against the greenback to $1.4268 and up 1.68 cents against the single currency to ¤1.1298, making a euro worth 88.5p.

CPI did not fall as far as expected as rises in the price of furniture, alcohol and clothing offset falls in energy billls and transport costs. Retailers were also reluctant to slash prices any further after heavy discounting in December.

Jonathan Loynes of Capital Economics described the modest decline as a “temporary aberration reflecting the partial reversal of some very aggressive price discounting in December”.

He added: “January's smaller-than-expected fall in consumer price inflation does little to dent the prospect of a return, after almost half a century, of deflation in the UK economy.”

Sterling has lost around a third of its value in recent months as the Bank of England slashed interest rates from 5% to an all time low of 1%. Despite CPI remaining well above the 2% target, the Bank looks set to lower rates again next month to 0.5% as well as embark on quantitative easing.

Howard Archer of Global Insight said: “It will not fundamentally alter the bank's view that consumer-price inflation is likely to substantially undershoot its 2% target level over the medium term due to the extreme weakness of the economy.

“We still expect the Bank of England to cut interest rates further in March. We expect interest rate to come down to a low of 0.25% in the second quarter.”