* Sterling edges away from 3-week low versus euro * Traders cite talk of central bank diversifying out of euros * But anticipation of ECB action seen limiting gains * UK inflation expectations rise but economy worries remain LONDON, August 29 (Reuters) - Sterling recovered from a three-week low against the euro on Wednesday, with traders citing reported central bank demand for the UK currency, but expectations of European Central Bank action soon to tackle the debt crisis limited its rise. The euro was down 0.3 percent at 79.18 pence, edging away from a three-week peak hit of 79.55 pence, with traders citing a European central bank diversifying euro reserves into alternatives, including sterling. But many analysts expected the euro to push higher in the coming days due to speculation the ECB will announce a bond-buying programme to lower borrowing costs for Spain and Italy at its Sept. 6 policy meeting. "We could see euro/sterling creep higher over the next two or three weeks," said Michael Derks, chief strategist at FXPro, adding this could push the euro above 80 pence. However, the single currency was expected to face stiff chart resistance before that level, including the Aug. 6 peak of 79.66 pence and the 100-day moving average at 79.98 pence. Against the dollar, sterling was up 0.1 percent against the dollar at $1.5830, well above Tuesday's one-week low of $1.5754. A survey showing a pick-up in UK inflation expectations also helped the pound, though the impact was tempered by ongoing worries about the fragility of the economy. CENTRAL BANKS Analysts said many investors were sidelined before a meeting of policymakers in Jackson Hole, Wyoming later this week, where market participants will be looking for clues on whether the U.S. Federal Reserve will opt for more monetary easing. Any hints from Fed chairman Ben Bernanke on further stimulus would dent the dollar, potentially pushing the pound towards last week's three-month high of $1.5912. But the anticipation of action by the ECB, combined with worries about the fragility of the UK economy, was expected to increase demand from investors to sell sterling in favour of euros. "The balance of risks is for the euro to move higher until we get beyond Jackson Hole," said Adam Cole, global head of currency strategy at RBC. A second reading of UK second-quarter GDP on Friday showed the recession was not as deep as initially estimated but the economy still contracted by 0.5 percent. This kept alive chances the Bank of England will opt for more quantitative easing (QE) later in the year. Analysts at Morgan Stanley said they expected near-term gains in sterling against the dollar. They have a long position and target $1.6050 but take a more negative view over the medium term because of concerns about UK economic weakness. "Safe-haven flows from Europe into sterling could start to slow down if the market believes that the ECB plan will be successful in stabilising markets, leaving sterling increasingly exposed to the bearish medium-term fundamentals," they said in a note. More QE would hurt the pound as it increases the supply of the currency.

Source