LONDON, June 3 (Reuters) - Sterling inched up against the euro and dollar on Tuesday as data showing a fall in euro zone inflation last month supported bets the European Central Bank will ease policy aggressively later this week.
In mid-morning trade in London the euro was down 0.1 percent on the day at 81.05 pence and sterling was up 0.1 percent against the dollar at $1.6765.
Inflation across the 18-nation euro zone slipped to just 0.5 percent in May, increasing the likelihood of easing measures from the ECB and highlighting the contrast with the Bank of England, which is expected to start raising interest rates within a year.
The immediate impact on euro/sterling was modest as the decline had been widely expected after German inflation figures on Monday came in well below analysts' forecasts.
But it helped keep the pound on the front-foot despite mild disappointment for sterling bulls from a survey showing the UK construction sector grew in May at its slowest pace in seven months.
"It's an indication of how divergent the fortunes of the two economies appear to be," said John Wraith, senior strategist at Bank of America-Merrill Lynch in London.
"The rate path of the UK and U.S. (central banks) is broadly similar, but you could make a case that the ECB will still be where it is now in three years time. It's difficult to see where growth in the euro zone is going to come from."
The Markit/CIPS UK Construction Purchasing Managers' Index (PMI) eased to 60.0 last month, below the 60.8 expected in a Reuters poll but still well above the 50 line that divides growth from contraction.
Sterling had run up to a 5-1/2 year peak against the dollar earlier in May. Over the last year the pound has appreciated some 10 percent against a basket of currencies on the growing assumption that the improving economy and red-hot housing market will force the BoE to raise rates faster than its euro zone and U.S. peers.
But a less febrile housing market has tempered more aggressive expectations on when the BoE will start raising interest rates and encouraged traders to cash in on that rally.
Tuesday's construction figures were the latest in a batch of recent reports, including a nine-month low in mortgage approvals, that suggest the housing market may be cooling.
That has tempered some of the more aggressive bets for BoE rate hikes, and put a renewed test of $1.70 against the dollar on the back burner for now. (Reporting by Jamie McGeever; Editing by Catherine Evans)