June 23 (Bloomberg) -- The dollar fell against the euro by the most in six weeks on speculation the Federal Reserve will temper expectations for an interest-rate increase this year in an attempt to lower borrowing costs.

Futures traders added to bets that Federal Open Market Committee will keep the benchmark rate close to zero for the rest of this year to support a return to economic growth. The greenback extended declines as European Central Bank council member Axel Weber said policy makers have already used up their room to cut borrowing costs, adding to speculation the euro- area’s benchmark rate will stay higher than the rate in the U.S.

“The market’s a little worried about the FOMC,” said Meg Browne, a senior currency strategist at Brown Brothers Harriman & Co. in New York. “They’re asking the FOMC to provide them with conflicting views. One is to indicate when they’re exiting quantitative easing, but they’re also looking for the Fed to extend the Treasury purchases.”

The U.S. currency weakened as much as 1.75 percent to $1.4108 per euro, the most since May 8. It traded at $1.4076 at 4:23 p.m. in New York, from $1.3865 yesterday. The greenback dropped 0.7 percent to 95.23 yen, the third day of declines. Japan’s currency depreciated 0.9 percent to 134.06 per euro.

The Fed will probably keep its interest-rate target for overnight loans between banks close to zero and continue its $300 billion program of Treasury purchases, according to a Bloomberg News survey of 58 economists before tomorrow’s statement. Traders cut bets the Fed will raise interest rates by at least a quarter-percentage point to 0.5 percent by December, lowering the odds to 42 percent from 49 percent a week ago.

Pound Weakens

The pound fell versus the euro by the most in almost three weeks after Bank of England Chief Economist Spencer Dale said a weaker currency was a “key channel” to spur economic growth.

Sterling fell as much as 1.4 percent to 85.99 pence per euro after Bank of England’s Dale said the central bank’s purchases of gilts from foreign investors can benefit the economy through a weaker exchange-rate. The U.K. currency has gained 9 percent versus the euro and 12 percent against the dollar in the last three months on signs the U.K.’s recession is abating.

“The BOE’s comments have been used as an excuse to sell sterling,” said Daragh Maher, deputy head of global foreign- exchange strategy in London at Calyon, the investment-banking unit of Credit Agricole SA. “The market has been looking for an argument to sell sterling and Dale’s comments fit the bill.”

The Australian and New Zealand dollars gained, after losing more than 2 percent yesterday. The Aussie rose 1.1 percent to 79.42 U.S. cents and the New Zealand’s dollar added 1.6 percent to 63.94 cents.

‘Damper on Yields’

“The market is worried that the Fed will put a damper on yields and that will take away support from the dollar,” said Henrik Gullberg, a currency strategist in London at Deutsche Bank AG, the world’s biggest foreign-exchange trader. “That’s the main reason the dollar looks vulnerable right now.”

Rates on U.S. 10-year notes and 30-year mortgages rose to 4 percent and 5.59 percent, respectively on June 11, the highest this year. The increase threatens the Fed’s plans to free up lending in credit markets by purchasing debt ranging from government notes to mortgage-backed securities.

The Treasury sold $40 billion in two-year notes today at a yield of 1.151 percent, the highest since November 2008.

‘Biased to Weaken’

The dollar will “better biased to weaken” after this week’s Fed policy meeting, according to Credit Suisse Group AG.

“The dollar’s immediate problem is market concern about the Fed’s inflation-fighting credibility,” a team of Credit Suisse currency strategists led by Ray Farris in London wrote in a note today, referring to the Fed’s purchases of assets. “We see ways for the Fed to salve some of these concerns, but we doubt the Fed will turn hawkish enough to support the dollar.”

The dollar also declined to the lowest in more than a week against the euro as the ECB’s Weber said the space for interest rates cuts that was created by the “dramatic worsening” in the economy and decline in inflation risk has already been used.

“The rate differentials will move once again in favor of the euro” as the odds drop for a Fed rate increase this year, said Michael Klawitter, a currency strategist at Dresdner Kleinwort in Frankfurt. “What we’ve heard from the ECB was confirmation,” providing support to the euro.

The central bank kept its benchmark rate at a record low of 1 percent this month and plans to offer banks 12-month loans for as much as they want in a new auction this week to help credit start flowing again.

Weber also said today that policy makers would have to bypass the banking system if banks didn’t provide cheap credit to companies and households.

To contact the reporters on this story: Oliver Biggadike in New York at obiggadike@bloomberg.netYe Xie in New York at yxie6@bloomberg.net

Last Updated: June 23, 2009 16:28 EDT