Sterling edges lower, BoE's Bailey signals no rush to raise rates

* Sterling dips, remains within recent range

* BoE's Bailey said allowing inflation overshoot is justified

* Markets still expect BoE rate hike this year

By Samuel Indyk

LONDON, May 29 (Reuters) - The British pound edged lower against the dollar on Friday as uncertainty over a possible U.S.-Iran peace deal kept investors cautious, while Bank of England Governor Andrew Bailey signalled there was no urgency to raise interest rates.

Reports said the U.S. and Iran had agreed to extend their ceasefire and lift shipping restrictions through the Strait of Hormuz, but the deal still awaits approval from U.S. President Donald Trump.

"If we get close to a ceasefire, some of these underlying macroeconomic developments start taking focus again," said Kirstine Kundby-Nielsen, senior FX strategist at Danske Bank.

"The UK economy isn't in great shape."

Britain's reliance on energy imports leaves it more exposed than the U.S. to higher fuel costs. While oil prices have fallen in recent weeks, they remain almost 30% higher than before the war.

Sterling was last down 0.2% at $1.3410, near the middle of the $1.33 to $1.35 range it has traded in over the past two weeks. It was down 0.1% for the week.

BOE IN NO RUSH TO HIKE

Before the conflict, investors had expected the BoE to cut rates at least twice this year as inflation eased towards target. Since late February, concerns that higher energy prices could reignite inflation have pushed markets to price in rate increases instead.

Money market futures now imply 32 basis points of tightening this year - one quarter-point hike and roughly a 30% chance of a second.

Bailey said allowing inflation to run above the BoE's 2% target was justified given uncertainty over the economic impact of the Iran war and the weak pace of growth, signalling policymakers can afford to wait before making any rate moves.

The BoE kept rates on hold last month and is widely expected to do so when it meets in June.

"I don't expect the Bank of England to hike to the extent that it's priced by market," Danske Bank's Kundby-Nielsen said.

"That should lift euro-sterling over the next year."

Against the euro, the pound was down 0.1% at 86.77 pence.

(Reporting by Samuel Indyk. Editing by Mark Potter)