Sept. 2 (Bloomberg) -- The dollar fell to a three-month low against the euro and dropped versus the yen on speculation the Federal Reserve will pause in its campaign of interest-rate increases.

Surging energy prices and the damage caused by Hurricane Katrina may slow growth further, after reports this week showed manufacturing slowing and a contraction in Chicago-area business for the first time since 2003. The U.S. currency's 8.6 percent advance against the euro this year was partly driven by a widening interest-rate advantage over Europe.

``All the market is talking about is Katrina, what it means and is the Fed going to pause,'' said Lee Ferridge, a proprietary trader at Rabobank Groep in London. ``It's just relentless at the moment, it's just dollar selling.''

Against the euro, the dollar weakened to $1.2539 at 9:07 a.m. in London from $1.2501 late yesterday in New York, according to electronic currency dealing system EBS. The dollar dropped to 109.55 yen, from 109.82.

The U.S. currency is down 1.6 percent versus the euro and 0.3 percent against the yen this week. It may fall to $1.27 per euro and 109 yen next week, Gibbs said.

``The Fed is probably going to hold to see how the economy plays out,'' said Greg Gibbs, a currency strategist at RBC Capital Markets in Sydney. ``There's even some concern the U.S. economy had already started to slow down before the hurricane. If that's the case, it's quite bearish for the dollar.''

Paring Bets on Fed

Traders are betting the Fed will raise interest rates one more time this year, down from pricing in a 50 percent chance of three rate increases at the beginning of the week.

Fed policy makers are likely to lift their target rate for overnight loans between banks to 3.75 percent at their Sept. 20 meeting and then stop, interest-rate futures show. The European Central Bank's benchmark rate is 2 percent.

The yield on the September federal fund futures contract was 3.565 percent today, showing traders see about a 70 percent chance the Fed's key rate will be 3.75 percent at this month's meeting. The odds were 100 percent two days ago.

The dollar may fail to benefit even as a report today will probably show U.S. employers added 190,000 jobs in August, according to analysts including Tohru Sasaki, a foreign-exchange strategist in Tokyo at JPMorgan Chase. The expected figure is based on the median estimate of economist surveyed by Bloomberg.

``U.S. payroll numbers are unlikely to give the dollar upward momentum, even if the numbers are good,'' said Sasaki, a former Bank of Japan head currency trader. ``Market sentiment toward the U.S. economy is worsening, buffeted by recent weaker data.''

UBS Cuts Forecast

UBS AG yesterday lowered its forecasts for the dollar. The firm now expects the U.S. currency to decline to $1.27 per euro in one month and $1.29 in three months, compared with its previous projection of $1.23 and $1.25. UBS predicts the dollar will drop to 108 yen in a month, down from 110.

A report yesterday showed a gauge of U.S. manufacturing fell for the first month in three in August and the National Association of Purchasing Management-Chicago said the previous day its gauge of regional manufacturing showed a contraction. Durable goods orders had the biggest decline in July since January 2004, an Aug. 24 Commerce Department report showed.

Ben Bernanke, a former Federal Reserve governor and current chairman of the president's Council of Economic Advisers, yesterday said jobs lost and disruption caused by Katrina will lower the third-quarter U.S. gross domestic product growth rate. He didn't say by how much.

The hurricane may reduce gross domestic product by 0.5 percent in the third quarter, according to Standard & Poor's.

Koizumi Polls

The yen headed for a fourth weekly gain in five against the dollar as Japanese stocks rose and polls showed rising approval ratings for Prime Minister Junichiro Koizumi before Sept. 11 elections.

Japan's economy, the world's second-biggest, is in a ``lasting and self-sustaining'' recovery, Bank of Japan Deputy Governor Toshiro Muto said today, indicating that deflation of more than seven years may be close to an end.

The Nikkei 225 Stock Average has risen 6.7 percent since Koizumi dissolved Parliament on Aug. 8. Koizumi called an election to see if voters support his plan to sell the postal system.

``Expectations foreign investors will keep putting more money into Japanese equities are supporting the yen,'' said Tetsu Aikawa, a currency sales manager in Tokyo at UFJ Bank Ltd., a unit of Japan's fourth-biggest lender. ``Growing support for Koizumi is also positive for the yen because he is considered a reformer. A victory means a stable administration, which will make it easier to promote reform.''

The yen may rise to around 109.60 per dollar before the payrolls data, he said.

To contact the reporter on this story: Kosuke Goto at at kgoto2@bloomberg.net

Last Updated: September 2, 2005 04:32 EDT