Jan. 2 (Bloomberg) -- The dollar declined to its weakest in three weeks against the euro on speculation the Federal Reserve will reduce interest rates this year while European Central Bank policy makers increase their benchmark.

The dollar slid against all 16 of the most actively traded currencies before a report this week that may show manufacturing growth stagnated in the world's largest economy. The Fed has held borrowing costs steady since June after a two-year campaign of raising them. ECB council member Erkki Liikanen suggested in an interview broadcast today that rates will rise in Europe.

``We've still got an ECB that's talking in incredibly hawkish terms,'' Simon Derrick, chief currency strategist at the Bank of New York, said in London. The comments contrast with the trend for U.S. rates, which is weakening the dollar, he said.

The currency fell to $1.3272 versus the euro by 11:49 a.m. in London, from $1.3201 in New York late yesterday, its biggest daily drop since Dec. 19. It earlier touched $1.3290, the weakest since Dec. 12. The U.S. currency fell to 118.83 yen from 119.05.

The dollar fell 10.2 percent against the euro last year.

A report from the Institute for Supply Management tomorrow will probably show U.S. manufacturing didn't expand last month, after contracting for the first time since April 2003. The survey may show a reading of 50, the dividing line between expansion and contraction, for December, compared with 49.5 in November, according to a Bloomberg News survey of economists.

Yield Premium

``The Fed will cut interest rates and the U.S. rate advantage will erode, weighing on the dollar,'' said Harvinder Kalirai, head of research in Sydney at State Street Corp.

The Fed has kept its overnight lending rate unchanged at 5.25 percent at its past four meetings, ending a two-year cycle of borrowing-cost increases. Interest-rate futures indicate the odds of a quarter-percentage-point rate cut by March were 17 percent on Dec. 29, up from 11 percent on Dec. 15.

U.S. economic expansion slowed to 2 percent in the third quarter, and 2.6 percent in the second quarter.

The yield premium investors earn on benchmark two-year U.S. bonds over similar-maturity German bunds narrowed to 0.885 percentage points today from 0.905 percentage points on Dec. 29.

Employers in the U.S. added 115,000 workers to their payrolls in December, ending a quarter in which job creation was the slowest in three years, according to the median estimate of economists surveyed by Bloomberg before the Jan. 5 report. The economy created 132,000 jobs the previous month.

Euro Extends Gains

The euro extended its gains today after the ECB's Liikanen said in an interview with broadcaster YLE that wage demands in Germany may spark inflationary pressure. Policy makers lifted their benchmark refinancing rate by a quarter percentage point to 3.5 percent on Dec. 7.

``The ECB look like they'll keep pushing up rates,'' said Matthew Jones, a senior currency dealer at Custom House Global Foreign Exchange in Sydney.

Growth in the euro region was 2.7 percent in the third quarter and 2.8 percent in the second. The Eurostat in Luxembourg releases the final estimate of third-quarter GDP next week.

The euro earlier rose to a record against the yen before reports that may add to signs the European Central Bank will raise rates faster than the Bank of Japan.

The jobless rate in Germany fell to its lowest in more than four years in December, a government report tomorrow may show, according to a Bloomberg survey of economists.

Manufacturing Growth

The European currency last year gained the most against the yen since its debut in 1999 as the ECB raised rates five times, compared with a single increase by the BOJ.

The yen fell 11.2 percent against the euro and 1.1 percent against the dollar in 2006. Europe's single currency rose as high as 157.85 yen, and traded at 157.75 yen.

The euro remained stronger after a report showed European manufacturing growth in December was little changed from the previous month.

``The headline outcome highlights a euro zone manufacturing sector that is still expanding at a robust pace,'' said Jodie Saul, a European economist at CIBC World Markets in London, in an e-mailed note to clients. ``There's nothing in the breakdown to alter the near-term monetary policy outlook.''

Royal Bank of Scotland Group Plc said its manufacturing index fell to 56.5, from 56.6 in November. A reading above 50 indicates growth.

Economists forecast the gauge, compiled by NTC Economics Ltd. from a survey of 3,000 purchasing managers, would rise to 56.8, the median of 25 forecasts in Bloomberg survey showed.

Currency movements today may be exaggerated and volumes be ``about 50 percent'' below average because of a public holiday in Japan and as U.S. financial markets observe a national day of mourning for former President Gerald R. Ford, said Robert Rennie, chief currency strategist at Westpac Banking Corp. in Sydney.

To contact the reporter on this story: Agnes Lovasz in London at alovasz@bloomberg.net; Ron Harui in Singapore at rharui@bloomberg.net

Last Updated: January 2, 2007 06:51 EST