Oct. 7 (Bloomberg) -- The yen dropped from near a three- year high against the euro as the Federal Reserve's announcement that it will buy commercial paper encouraged investors to resume buying higher-yielding assets funded in Japan.

The greenback fell from a 14-month high versus the euro on speculation the Fed's plan will ease the credit squeeze. The dollar depreciated versus the yen as Fed Chairman Ben S. Bernanke signaled policy makers are ready to lower interest rates to protect the economy.

``They are taking measures to restore confidence,'' said Vassili Serebriakov, a currency strategist at Wells Fargo & Co. in New York. ``The yen and the dollar are overbought in the short term. Reduced risk aversion works favorably for the euro- yen.''

The yen declined 0.3 percent to 137.94 against the euro at 4:01 p.m. in New York, from 137.50 yesterday, when it touched 135.05, the strongest since September 2005. Japan's currency rose 0.5 percent to 101.31 per dollar, from 101.82. The dollar fell 0.9 percent to $1.3616 per euro from $1.3499. It touched $1.3444 yesterday, the strongest since August 2007.

The pound rose 0.2 percent to $1.7482 on speculation the U.K. will bail out banks. Prime Minister Gordon Brown's government is preparing a rescue that will include capital injections, three people familiar with the decision said.

BOE Outlook

The Bank of England will reduce its 5 percent benchmark rate by a quarter-percentage point on Oct. 9, according to the median forecast of 61 economists surveyed by Bloomberg News. Finance ministers and central bankers from the Group of Seven nations will meet in Washington the next day to discuss the deepening credit-market crisis.

``There is a degree of optimism that we will see coordinated rate cuts, which is increasing risk appetite and weighing on the yen,'' said Lee Hardman, a currency strategist in London at Bank of Tokyo-Mitsubishi Ltd.

Interest-rate futures indicate the Fed will lower its 2 percent target lending rate by at least a half-percentage point by its next meeting on Oct. 29 and the European Central Bank will cut its 4.25 percent main refinancing rate by year-end.

The Fed ``will need to consider whether the current stance of policy remains appropriate,'' Bernanke said in a speech in Washington after the central bank moved to backstop the corporate debt market.

The Reserve Bank of Australia reduced its cash target to 6 percent, the lowest since November 2006. Iceland said it will fix the krona at a rate corresponding to 131 per euro, effective today, to help stem a collapse of its financial system. The currency has lost 20.5 percent versus the euro in three months.

Commercial Paper

The Fed's decision to buy commercial paper follows a slide in the market for short-term corporate debt to a three-year low of $1.6 trillion last week as investors fled even companies with few links to the subprime mortgage crisis.

``They are clearly pulling out every imaginable stop to get the credit market moving again,'' said Shaun Osborne, chief currency strategist at TD Securities Inc. in Toronto. ``It will reduce risk aversion at least temporarily. But beyond a short- term bounce, it's hard seeing the credit crunch simply fading away as an issue.''

The U.S. currency fell 1.4 percent to 7.1041 Swedish krona and 1.1 percent to 6.1608 Norwegian krone on speculation the Fed's purchase of commercial paper will encourage the world's banks to lend to each other, reducing demand for dollar funding.

``The dollar's been acting as a safe haven as the credit crunch has gone global,'' said Richard Franulovich, a senior currency strategist at Westpac Banking Corp. in New York. ``Anything that helps unfreeze markets boosts risk appetite. We should see the dollar take a hit.''

Demand for Dollars

The greenback gained 5.8 percent versus the euro last week in its biggest rally since the European currency's 1999 debut amid the credit squeeze. Before the Fed's announcement, the overnight London interbank offered rate, or Libor, rose today to 3.94 percent, from 2.37 percent.

Morgan Stanley raised its forecast for the dollar versus the euro in a research note today, citing ``cross-border risk reduction'' in a coming ``global recession'' and speculation Europe's banking sector will weigh on the 15-nation currency.

The dollar will strengthen to $1.30 per euro by year-end and $1.25 by December 2009, compared with previous forecasts of $1.40 and $1.32, wrote Stephen Jen, global head of currency research in London.

Morgan Stanley predicted the yen will strengthen to 96 per U.S. dollar by year-end on speculation a global slowdown will encourage Japanese inventors to repatriate ``much of their investment.'' It previously forecast the yen would drop to 107.

To contact the reporters on this story: Ye Xie in New York at yxie6@bloomberg.net; Daniel Kruger in New York at dkruger1@bloomberg.net

Last Updated: October 7, 2008 16:06 EDT