The immediate cause of the pound’s muscular surge through the $2 level last week was sharply divergent inflation data in the US and the UK. What happens to sterling from now on against the US currency should be determined more by growth in America than by prices.

In Britain, for the first time in the ten years since Bank of England independence, Mervyn King, the Bank’s Governor, was compelled to write his much-anticipated letter to the Chancellor explaining why inflation had reached beyond the Bank’s target range and what he was going to do about it.

It was a somewhat sanguine performance, suggesting that the Bank remains calm about a headline inflation reading of 3.1 per cent year-on-year and is reasonably confident that much of the work necessary to get inflation back into its box has been done already through last year’s rate increases.

Yet financial markets and economists assume that the Bank is not yet done in its tightening and that rates will go at least another 25 basis points higher in the coming months.

As it happens, on the very same day that St Mervyn delivered his First Epistle to the Brownites, the United States was also publishing inflation data. The Federal Reserve is not required, as the Bank is, to write anything to anybody about the inflation data, but if it were the Fed’s policymakers might have felt like penning a kind of “Wish You Were Here” postcard to their counterparts at the Bank of England.

In sharp contrast with Britain, core US consumer prices barely moved in March. The 0.1 percentage point increase in the CPI officially recorded last month over February was, in fact, the result of a statistical rounding up — prices actually increased by just 0.06 percent in March.

The essentially benign performance was better reflected in the accompanying data. Year-on-year core inflation was 2.5 per cent, its lowest level in almost a year, and down from the outright alarming 2.9 per cent recorded last autumn.

Though there must be the usual caveats about one month’s figures, and while US officials still prefer to use other inflation data in guiding policy, the numbers certainly seemed to suggest that the US has finally turned the corner on inflation. That means at least that the slight possibility that the Fed might actually increase interest rates some time this year has receded. So if the Bank of England in fact pushes short-term rates to 5.5 per cent, as expected, rates at the near end of the yield curve will be lower in Britain than they are in the US (where the Fed funds rate is still 5.25 per cent) for the first time in a long while.

This can only be positive for sterling and evidently explains last week’s renewed push upwards for the currency.

But what next? Sterling’s strength is obviously based not just on immediate interest-rate differentials but on expectations for interest rates in the next year or so. After last week’s inflation figures in the US, markets are more confident than ever that the Fed will cut rates this year. While American growth has weakened in the past six months, the stubbornness of inflation figures has prevented any serious discussion at the Fed of moves to revive flagging demand with a monetary stimulus.

Attention turns then to the outlook for US demand. On Friday we will get the first reading on gross domestic product growth in the first quarter of 2007. Economists expect the data to show continuing weakness, with growth somewhere between 1.5 and 2 per cent. That number is, of course, already, in the purest sense, history. The real question is what happens now that the first quarter is out of the way. The housing market is clearly proving a drag on overall spending longer than expected.

Mickey Levy, chief economist at Bank of America in New York, notes that the bank’s own mortgage data point to significant further housing weakness in the next few months. On top of that, capital spending is also subtracting sizeable amounts from GDP growth as companies remain deeply cautious. Against that, the dollar’s weakness in the past year is starting to be reflected in an improved external performance, helping to offset some of the domestic demand weakness. Consumption continues to be healthy; the first-quarter figures are likely to show considerable consumer momentum heading into the second quarter.

But whether this can continue depends in large part on employment, which has been growing impressively in recent months. Jan Hatzius, the chief US economist at Goldman Sachs, says that employment is “the last shoe to drop” in the US slowdown. He notes that employment has been unusually strong in the housing sector, despite the precipitous decline in activity there. Employers may have been holding off significant payroll reductions in hopes of an upturn that still looks some way off.

There will be a silver lining should employment growth decline. Labour productivity, which has been significantly weak in the past two years, will accelerate as employment slows, further depressing inflationary pressures and elevating the long-run potential growth rate.

That, of course, will give the Fed even more room to cut rates in the next year if demand really does slow further. The cheap dollar may be about to get even cheaper.

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