The pound has recovered against sterling as new figures show that the British inflation rate and retail sales growth both fell in June.

The pound closed at 85.5p against sterling in late trade from 85.06p on Monday as British inflation fell to a 12-monthly figure of 3.7 per cent in June from 4.2 per cent in May, lessening pressure on the Bank of England's monetary policy committee to raise interest rates.

Analysts expected inflation to fall to 3.9 per cent. Share prices surged on London's stock market after the better-than-expected inflation figures, which also prompting a sharp advance in government gilt-edged prices. The FTSE 100 index climbed above the 6,000 to close 142 points higher at 6,100.2, within in sight of the record 6,150 peak reached in April.

City economists were surprised by the scale of improvement in last month's inflation data, while early strength on Wall Street also encouraged the market. The Bank of England has raised rates six times in a year in a bid to take some of the steam out of inflation.

However, underlying inflation at an annual rate of 2.8 per cent remains above the government's official target of 2.5 per cent.

Mr Pat O'Sullivan, economist at AIB, said today would be critical for sterling, as its direction would hinge on average earnings data due for release.

At the same time, the British Retail Consortium said the value of retail sales in Britain had fallen for the first time for three years in June.

Total value of retail sales fell 0.1 per cent in June compared to the same period last year. This was the first time the index had been negative since March, 1995.

In May the figure increased by 3.7 per cent from the same period in 1997. The figures were especially good news for exporters and manufacturers, who have watched the central bank base rate increases with dismay.

However, they will have to wait until today - when the average earnings are released - to get a clearer picture of sterling's likely direction.

Average earnings are taken particularly seriously by the markets as these figures were used by the Bank of England as a prime reason to raise interest rates last time around.

According to Mr O'Sullivan, if average earnings come in above 5 per cent, sterling will once again pick up and the pound will move back below 85p against sterling

"Average earnings is a three-month average and the large bonuses paid in April will still be in the data, so I would not expect much of a slowdown," he said.

However, if the rise is below 4.5 per cent, sterling may slip a little further.

He added that sterling also suffered as the deutschmark strengthened on news of the International Monetary Fund loans to Russia, which took pressure off the rouble.

The August inflation report will also be very important for assessing sterling's future direction, according to Mr O'Sullivan.