Sterling dropped sharply against the yen and also weakened versus the dollar and the euro on Thursday as investors focused on monetary policy divergence after last week's sell-off in gilts and the pound.

Money markets priced in around 50 bps of rate hikes by the Bank of Japan in 2025 after Governor Kazuo Ueda said on Wednesday the bank will debate whether to raise interest rates next week.

The Bank of England is expected to ease its monetary policy, leading sterling to drop 0.77% versus the Japanese currency at 190, hitting a fresh 1-1/2-month low at 189.72.

In Britain, heavy government bond supply and concerns about UK fiscal challenges pressured asset prices last week, driving UK borrowing costs to their highest since 2008.

Yields on 10-year UK government bonds fell 2 basis points (bps) after dropping 14.5 bps the day before on weak inflation data on both sides of the Atlantic. Bond yields move inversely with prices.

Analysts said it was too soon for optimism about a sterling rebound, but the recovery in the bond market was a positive.

"Sterling found some short-term stability, which is warranted, and inflation numbers were helpful from this point of view," said Paul Mackel, global head of forex research at HSBC.

"However, fiscal dynamics will remain in focus and we still see sterling struggling versus the dollar," he added.

British inflation slowed unexpectedly last month, and core measures of price growth, tracked by the Bank of England, fell sharply, according to official data.

The pound fell 0.25% to $1.22. It hit $1.2097 on Monday, its lowest level since November 2023.

The U.S. dollar steadied on Thursday as investors focused on Donald Trump's inauguration.

Britain's economic output returned to growth in November but expanded by less than expected.

Markets increased their bets on future Bank of England rate cuts, pricing 59 basis points in 2025.

The Bank of England should move quickly to bring down rates given signs of a slowdown in Britain's economy, said rate setter Alan Taylor, adding he expected the central bank to cut interest rates four times in 2025.

The single currency rose 0.3% to 84.31 pence. It hit 84.50 pence on Wednesday, its highest level since mid-September.

(Reporting by Stefano Rebaudo; editing by Barbara Lewis)