Jan. 6 (Bloomberg) -- The euro fell to a three-week low against the dollar on speculation slowing inflation will prompt the European Central Bank to cut interest rates more than forecast.

The common currency had a record two-day loss versus the pound and dropped against the yen as derivatives trading showed investors are betting the ECB will cut its key rate by at least 25 basis points next week. The dollar advanced against yen and the Swiss franc after U.S. President-elect Barack Obama was said to favor an economic stimulus package of about $775 billion.

“We had weaker inflation numbers out of euro-land, which really solidifies the view that there is increasingly more room for the ECB to be more aggressive on rate cuts,” said Mike Moran, senior currency strategist at Standard Chartered in New York. “That will naturally put more pressure on the euro from an interest-rate differential perspective. We’re seeing interest-rate differentials really come back into play in terms of a currency driver.”

The euro fell 0.8 percent to $1.3523 at 3:17 p.m. in New York, from $1.3635 yesterday. It earlier touched $1.3313, the lowest level since Dec. 12. The euro declined 0.3 percent to 126.92 yen, from 127.31. The dollar rose 0.4 percent to 93.85 yen from 93.44 yen, and touched 94.63 yen, the highest level since Dec. 1.

The dollar remained high after the minutes of Federal Reserve’s meeting in December showed policy makers saw “substantial” risks to the slumping economy. The Fed reduced the target rate for overnight loans between banks to a range of zero to 0.25 percent and pledged to expand emergency loans if necessary.

‘Sets The Stage’

“It eventually sets the stage for stabilization and a return to growth of the U.S. economy and that seems more positive than negative for the U.S. dollar,” said Nick Bennenbroek, head of currency strategy at Wells Fargo Bank in New York.

The yen fell 3.1 percent against Brazil’s real and 1.3 percent versus Mexico’s peso on speculation investors may resume carry trade where they borrow from low-interest-rate countries to buy higher-yielding assets elsewhere.

The Japanese currency gained 29 percent against the euro last year as $1 trillion in losses on mortgage-related securities worldwide prompted Japanese investors to shun higher- yielding overseas assets.

The yen’s real effective exchange rate, a measure of its value against the currencies of 15 of Japan’s trading partners after adjustment for inflation, rose 5.1 percent in December from a month earlier to the highest level since November 2001, the Bank of Japan said today in Tokyo.

Trend Line

The dollar may appreciate to 100 yen “in the not too distant future,” after it rose above the trend line that tracks its decline since mid-September, Tom Fitzpatrick, chief technical strategist at Citigroup Global Markets Inc. in New York and his London-based colleague Shyam Devani, wrote in a research note to clients today.

Europe’s single currency fell 2.4 percent to 91.11 pence, increasing its two-day losses to 5.4 percent, the biggest since the European currency’s debut a decade ago. Inflation in the euro area slowed to 1.6 percent last month, from 2.1 percent in November, the European Union’s statistics office in Luxembourg said today. That was less than the 1.8 percent predicted in a median forecast of 28 economists surveyed by Bloomberg.

ECB council member Vitor Constancio said in a speech in Lisbon yesterday that policy makers are prepared to cut interest rates if necessary to keep inflation on target just below 2 percent.

Interest-Rate Differentials

The ECB cut interest rates by 1.75 percentage points since early October to 2.5 percent as the region entered a recession. Policy makers will lower the main rate by at least 25 basis points at the next meeting on Jan. 15, according to a Credit Suisse Group AG gauge of probability, based on overnight index- swap rates.

At 0.81 percent, the two-year Treasury yield was 0.93 percentage point lower than the same-maturity German bund. The gap has narrowed from 1.22 at the beginning of December, making the U.S. securities more attractive.

The dollar gained 2 percent versus the euro yesterday after a Democratic aide said Obama told House Speaker Nancy Pelosi that he favors a U.S. economic stimulus plan of about $775 billion.

The Dollar Index traded on ICE futures, which tracks the greenback against six of U.S. major trading partners, touched 84.023, the highest since Dec. 12. The index has increased 14 percent since the end of July as the economies in the euro-zone, Japan and U.K. fell into a recession, prompting investors to seek shelter in the Treasuries.

Emerging Markets

The U.S. currency climbed 0.9 percent to 1.119 Swiss francs today. It also gained versus some emerging market currencies, rising 0.3 percent against the Indian rupee.

Emerging-market currencies are poised for further losses as recessions force wealthier nations to rein in overseas investment, according to Morgan Stanley.

One-third of the world’s wealth has been wiped out by the financial crisis and this will have a lasting effect on global consumption, wrote London-based Stephen Jen, chief strategist for emerging markets in the bank’s sales and trading arm. Foreign direct investment in the developing nations of Asia, Europe and Latin America is already starting to cool, he said.

Dresdner Kleinwort said the dollar’s strength was driven partly by a “seasonal pattern.”

“Over the past 10 years, the dollar index had a positive return in January in 71 percent of all cases,” said Michael Klawitter, a currency strategist at Dresdner Kleinwort in Frankfurt. “January or the first quarter is by far the best period for the dollar.” The euro will fall below $1.30 in the “coming weeks,” Dresdner said.

To contact the reporters on this story: Ye Xie in New York at yxie6@bloomberg.net; Molly Seltzer in New York: mseltzer4@bloomberg.net

Last Updated: January 6, 2009 15:20 EST