Feb. 21 (Bloomberg) -- The yen dropped to a record low versus the euro and approached the weakest in four years against the dollar after the Bank of Japan raised interest rates and said further increases would be gradual.

Investors pushed the Japanese currency to near the lowest in a decade against the Australian dollar. Japan's borrowing costs, the lowest among major economies, diminish the allure of yen- denominated assets.

``The yen will weaken further in coming months,'' said Axel Merk, head of Merk Investments LLC in Palo Alto, California, which has $60 million in assets and runs the Merk Hard Currency Fund. ``The BOJ will suppress the yen. There isn't any sign of a crisis for the carry trade,'' referring to the practice of selling yen to buy higher-yielding assets elsewhere.

Japan's currency dropped to 120.88 against the dollar at 4 p.m. in New York, from 120.02 yesterday, approaching the four- year low of 122.19 on Jan. 29. The yen declined to 158.82 per euro from 157.68, after reaching an all-time low of 159.04.

The yen fell to 95.64 per Australian dollar from 94.38, close to the 96.45 level reached on Jan. 24, the weakest since May 1997. It also weakened to 236.20 per British pound from 234.68, near the level of 241.52 reached on Jan. 23, the lowest since September 1992.

Fed Minutes

The dollar was higher against the yen after the minutes from the Federal Reserve's Jan. 31 meeting showed policy makers discussed whether the bias toward rate increases should be removed. They decided against dropping the bias as inflation risks remain, the minutes said.

The U.S. central bank kept its benchmark interest rate at 5.25 percent during the meeting. A U.S. report today showed consumer price increases exceeded economists' forecasts last month.

Fed Bank of St. Louis President William Poole said inflation seems poised to be ``gradually tilting down'' this year, and a larger-than-forecast increase in consumer prices during January doesn't alter that view.

In contrast, Fed Bank of San Francisco President Janet Yellen said she is ``especially concerned'' about the risks of faster inflation.

The U.S. currency traded at $1.3139 per euro from $1.3138 yesterday, rebounding from an intra-day low of $1.3166.

Canada's Dollar

Canada's dollar rose to a seven-week high of 86.25 U.S. cents and rallied versus the yen, the British pound and euro after a government report showed retail sales in December surged at the fastest pace in nine years.

Bank of Japan Governor Toshihiko Fukui said in a press conference following the rate decision that carry trades could distort the economy, though the foreign exchange market wasn't the main reason for the decision to increase the overnight lending rate by a quarter-percentage point to 0.5 percent.

Japan's central bank lifted borrowing costs for the first time in seven months and suggested it won't raise interest rates consecutively.

The Bank of England's benchmark rate is 5.25 percent, while the European Central Bank's main borrowing cost is 3.50 percent. Australia's overnight cash rate target is at a six-year high of 6.25 percent and New Zealand's official cash rate is 7.25 percent.

`Alive and Well'

``The BOJ didn't do or say anything to discourage the carry trade,'' said Steven Butler, director of foreign exchange trading at Scotia Capital Inc. in Toronto. ``Rates are still extremely low in Japan. Carry trade is alive and well. Expect more yen weakness to come.''

Implied volatility on one-month yen options against the euro dropped to 7.1 percent, the lowest since Jan. 24. The decrease may encourage carry trades, as it implies smaller exchange-rate fluctuation risk. The one-month implied volatility of yen against the dollar, the pound and the Australian currency also declined.

The yen also fell as the Japanese central bank predicted in its February economic report that a drop in oil costs may cause core consumer prices, which include energy, to fall temporarily. The measure rose 0.1 percent in December, slowing from 0.2 percent in November.

The yen has declined 4.2 percent against the dollar and 6 percent versus the euro in the past six months as low interest rates in Japan encouraged investors to put on carry trades.

The Swiss franc, another popular currency to fund carry trades, touched 1.6288 against the euro, matching the all-time low reached Feb. 14. Switzerland's benchmark interest rate is 2 percent, the second-lowest among industrialized nations after Japan's.

The franc traded at 1.6264 per euro from 1.6246 yesterday, and was quoted at 1.2381 per dollar from 1.2365.

The dollar earlier extended its gain against the yen as the U.S. consumer price index rose 0.2 percent in January after a revised 0.4 percent increase a month earlier. It beat the median forecast of 0.1 percent in a Bloomberg survey.

The consumer price index excluding food and energy gained 0.3 percent last month, from a revised 0.1 percent, compared with the median forecast of a 0.2 percent increase.

To contact the reporters on this story: Min Zeng in New York at mzeng2@bloomberg.net; Ye Xie in New York at yxie6@bloomberg.net.

Last Updated: February 21, 2007 16:01 EST