LONDON, Aug 8 (Reuters) - Sterling rose against the dollar and the euro on Wednesday as a quarterly inflation report from the Bank of England signalled interest rates may need to rise once more to help bring inflation down to its 2 percent target.

Returning risk appetite also favoured sterling as investors moved back into riskier carry trades, where low-yielding currencies are borrowed to fund higher return assets.

The central bank's report showed consumer price inflation fractionally above the 2 percent target in two years if interest rates rise in line with market expectations -- another quarter-percentage point to 6 percent by the first quarter of 2008.

Inflation would clearly overshoot the target if rates stayed at their current 5.75 percent, the report showed.

"A more positive stance on interest rates in the UK combined with better risk appetite spelt a stronger sterling," said Simon Derrick, head of currency research at Bank of New York.

"There's been again a fresh recovery in risk appetite, with European equities doing really well and whenever you see that the dollar weakens against currencies like sterling and the euro," he said.

By 1424 GMT the pound was up 0.8 percent at $2.0392 down from $2.0240 just before the report was released.

The euro was down 0.3 percent at 67.71 pence. Five rate hikes since last August have taken UK borrowing costs up to 5.75 percent -- the highest in the Group of Seven nations -- boosting sterling's yield appeal.

While another rate hike would bolster the pound's higher-yielding status further, some analysts say that move may not come soon.

"The Bank of England is in no immediate hurry to raise interest rates again given the current particular major uncertainties surrounding both the inflation and growth outlooks," Global Insight economist Howard Archer said.

Source supplied by: Reuters