Higher car production propelled British factory output to its fastest monthly pace in 1-1/2 years in July, according to official data, fuelling expectations the economy has emerged from recession.

The Office for National Statistics said factory output rose 0.9 percent in July -- three times faster than analysts had expected and the biggest rise since January 2008.

Sterling shot up and gilt futures fell as investors bet the deepest recession in decades would finally end in the third quarter.

Today's figures reaffirm our view that the UK economy could well post positive growth in the third quarter, said Colin Ellis, economist at Daiwa Securities.

The increase was driven by a 10.4 percent rise in motor vehicle production, suggesting car scrappage subsidies are significantly boosting industry.

The wider measure of industrial output, which includes energy production, rose 0.5 percent on the month -- more than twice as fast as expected -- despite falls in utility, mining and oil output.

Analysts said gross domestic product (GDP) in the third quarter could rise by 0.2 percent or more but the figures did little to alter expectations that monetary and fiscal policy will remain loose for some time to come.

The Bank of England is widely expected to hold interest rates at a record low of 0.5 percent this month and keep in place its 175 billion pound asset purchase program.

SLUGGISH RECOVERY

Other recent surveys have also suggested the British economy is picking up, as demand in other countries improves and the relative weakness of the pound makes UK firms more competitive.

The government's car scrappage scheme, which gives motorists a cash incentive to trade in their old cars for new ones, has also given Britain's ailing car industry a shot in the arm in recent months.

But the scheme is due to end soon and other factors, such as rising unemployment and the prospect of government spending cuts next year, are likely to limit the extent of any future growth.

Figures overnight from the British Retail Consortium showed like-for-like retail sales values fell 0.1 percent on the year in August -- the first fall since May and following a 1.8 percent rise in July.

This morning's BRC retail sales figures are a reminder that, while improving overseas conditions are helping the export-dependent industrial sector to recover, the domestic economy still has plenty of problems to overcome, said Jonathan Loynes, chief European economist at Capital Economics.

As such, we expect the UK to continue to lag behind in the global recovery.

(Reporting by Fiona Shaikh and Christina Fincher; editing by Patrick Graham/Ruth Pitchford)

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