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The pound has fallen after a credit rating agency warned the UK faced a "formidable" challenge to cut its budget deficit.

It fell 1% against the dollar to $1.437 after Fitch published its report, but later pared losses.

Fitch said the deficit must be reduced more quickly than set out by the former Labour government in April.

The Treasury said the Fitch report "made the case" for its policy of speeding up spending cuts.

"Fitch's report makes the case clearly for an acceleration of deficit reduction, particularly in light of events in the euro-area sovereign debt market in recent months," a spokesperson said.

Fitch noted that the new coalition government had acted "very quickly", making deficit reduction a top priority and identifying £6bn of savings.

But it also sounded a note of caution. It said the new Office of Budget Responsibility, established to make an independent assessment of the UK economy, could deliver a more pessimistic outlook, offsetting the impact of efforts to cut spending.

It also pointed out that most other countries had pledged to cut their fiscal deficits by more than the UK has.

"With other European sovereigns strengthening their fiscal consolidation plans and market concerns about sovereign risk in advanced countries increasing, both the size of the UK deficit currently projected for 2011 and the failure to reduce it to 3% of GDP within five years are striking," the report said.

Fitch did not revise the UK's credit rating - AAA - but its comments suggest that it would consider doing so if the pace of deficit reduction was not increased.

Credit ratings are important as they influence how much it costs governments to borrow on open markets.