Sterling touched its lowest level since October 2006 at $1.8617.

Measured against a basket of trade-weighted currencies, the pound is now at its weakest level since 1996.

The pound dropped sharply on Wednesday after the Bank of England issued its gloomiest assessment yet of the health of the UK economy.

The Bank's governor Mervyn King said economic growth would be flat for the next year or so and that inflation would rise to 5% or above before falling.

Economists had thought inflation would prevent the Bank of England from cutting rates, but the Bank's suggestion that inflation will begin to ease raised expectations of interest rate cuts and this hit the pound.

Lower interest rates mean investors get lower returns on sterling deposits, which makes the pound less attractive.

'Dramatic collapse'

Simon Derrick, currency strategist at Bank of New York Mellon, called pound's fall this week a "dramatic collapse" that recalled the aftermath of sterling's ejection from European Exchange Rate Mechanism (ERM) in 1992.

Expectations of lower interest rates have driven sterling lower

However, he said the currency's slide should begin to ease.

"Even within the most ferocious sterling downtrends in the past, significant corrections emerged in the middle of the moves," he said.

Recent official figures have already shown the UK is struggling with high inflation and faltering growth.

Fears about European growth have also helped the dollar bounce back from record lows.

The US economy is still reeling from the credit crisis but analysts say the deteriorating outlook elsewhere in the world has given the dollar a boost.

Falling commodity prices have also supported the US currency. Investors had bought gold and oil to protect against dollar weakness and are now unwinding their positions.

The euro was trading at $1.4910 on Thursday, slightly above the 6-month low of $1.4815 struck this week. Earlier this year, the euro was trading at $1.60.

The euro has been further undermined by the military conflict in Georgia.

BBC