(Updates after reaction to UK PMI data, fresh quote)
* Sterling index at highest since mid-January
* Solid UK services PMI bolsters sentiment
* SONIA curve pricing in chance of a rate hike in early 2015
By Anirban Nag
LONDON, Sept 4 (Reuters) - Sterling hit a 7-1/2 month peakagainst a trade-weighted basket of currencies on Wednesday,after data showed the UK services sector expanding at itsfastest pace in more than six years in August.
The data added to growing evidence of a broad-based pick upin the UK economy and bolstered market expectations that theBank of England may have to tighten monetary policy well beforeit has flagged.
Sterling rose to a fresh 3-1/2 month high against the euroafter the PMI survey showed a reading of 60.5 in August whichwas better-than-expected and amongst the highest in thedeveloped world.
The single currency fell to 84.38 pence, itslowest since mid-May, and down 0.25 percent on the day. It wastrading at 84.52 before the data was released.
Against the dollar, sterling hit a session high of $1.5612 after the data, and 0.3 percent higher on the day. Allof which saw sterling's trade-weighted index at 82.2, itshighest since January 17.
"The services sector PMI exceeded expectations and giventhat construction and manufacturing were also better thanexpected, the recovery is broad-based and that is good news,"said Sasha Nugent, currency analyst at Caxton FX.
"We expect sterling to rise, more so against the euro. Theeuro, we expect, to gradually drop to 83 pence."
The euro was also weighed by expectations that theEuropean Central Bank may talk down rising short term marketrates and pledge to keep policy accommodative for longer. TheECB's rate setting committee meets on Thursday.
RISING SHORT TERM RATES
Earlier this week, British construction and manufacturingsector PMIs beat expectations.
The data along with rising short-term money rates have underpinned the pound. The 18-month sterlingovernight interbank average (SONIA) rate is at 0.5100 percent,up from 0.46375 percent at the end of August.
The steady rise in short term money market rates is posing achallenge to central bank Governor Mark Carney's forwardguidance plan. Under the plan, Carney has pledged to keep thebank rate at a record low and monetary policy loose until thejobless rate drops to 7 percent.
He expects that level to be reached in three years from thecurrent 7.8 percent, but markets, as reflected in the SONIAcurve, are pricing in a chance of tightening in early 2015.
Morgan Stanley (Xetra: 885836 - news) strategists said there is a risk that thecurrency could give up some gains if the BoE warned againstrising market interest rates this week. The BoE's MonetaryPolicy Committee starts a two-day meeting on Wednesday.
"We suggest some caution ahead of the BoE meeting where theMPC (KOSDAQ: 050540.KQ - news) has the opportunity to push back against the rise in marketrate expectations developed since the announcement of guidance,"Morgan Stanley said in a morning note.
(editing by Ron Askew)