Jan. 4 (Bloomberg) -- The dollar had the biggest two-day drop against the euro in five years after the Federal Reserve suggested it is closer to halting its interest-rate increases.

A shift in Fed policy may prevent a further widening of the yield advantage on U.S. assets that pushed the dollar up more than 14 percent against the euro and yen in 2005. A European Union report today showed inflation exceeded the European Central Bank's target for an 11th consecutive month.

``There's a dollar-bearishness out there right now,'' said Peter Lorraine, a managing director of foreign-exchange trading at Brown Brothers Harriman & Co. in New York. ``Once the Fed says they're getting near the end, the dollar is falling.''

The dollar weakened 0.8 percent to $1.2119 per euro by 5 p.m. in New York, from $1.2018 late yesterday, when it fell 1.7 percent. The U.S. currency was little changed at 116.10 yen, declining as low as 115.60 in Asian trading. The 2.5 percent two- day tumble against the euro is the most since 3.1 percent in January 2001.

``The market is premature in pricing in a peak just yet,'' said Adam Cole, senior currency strategist in London at RBC Capital Markets Ltd. ``We'll probably see a reversal'' of the dollar's decline, he said.

The number of rate increases needed to control inflation ``probably would not be large,'' yesterday's minutes from the Fed's December policy meeting showed.

`Some Nervousness'

Investors are still pricing in a quarter percentage-point rise in the target rate for overnight lending between banks to 4.50 percent at the Fed's Jan. 31 meeting. Interest-rate futures traders cut bets on the odds of higher rates in March, to as low as 44 percent, after the minutes were released yesterday.

``Fed rate hikes aren't going to be as pronounced'' as last year, said Steven Englander, chief currency strategist for the Americas at Barclays Capital Inc. in New York. ``We're at the beginning of the year, so people came in without positions and they're happy to jump on the trend.'' He expects the dollar to weaken to $1.23 per euro in three months.

The dollar pared its loss against the euro as yields on U.S. Treasury notes rose, increasing the gap with similar maturity German debt. The yield premium on U.S. bonds widened to a five- year high in 2005, helping the dollar to its biggest annual gain since 1999.

Some investors are selling the dollar to avoid a repeat of what happened in January last year when they incorrectly bet the dollar would continue a three-year decline, said Neil Jones, a director of foreign-exchange sales at BNP Paribas SA in London. The dollar rose 1 percent against the yen and 3.9 percent versus the euro in January 2005 after losing 6.8 percent and 9 percent, respectively, in the fourth quarter of the previous year.

``There are players, including hedge funds and pension funds, establishing new longs in the euro at the start of the year,'' said Lee Ferridge, a proprietary trader at Rabobank Groep in London. A long position is a bet that a currency will gain over a period of time.

Interest-Rate Gap

The Fed has boosted its benchmark rate 13 straight times since June 2004, to 4.25 percent last month. The ECB lifted its rate in December for the first time in five years while the Bank of Japan has signaled a policy of holding rates near zero to fight deflation may end this year.

Interest-rate futures show traders expect the ECB to lift its benchmark rate at least twice this year. Consumer prices rose 2.2 percent from a year ago, the EU said. The ECB aims to keep inflation at about 2 percent.

Employment Report

Losses in the dollar may be limited on speculation a government report in two days will show the U.S. economy in December added more jobs than the monthly average since the Fed started raising rates in June 2004.

The Labor Department report on Jan. 6 will show U.S. employers created 200,000 new positions, according to the median estimate of 58 economists surveyed by Bloomberg. Economists predict the jobless rate will hold at 5 percent.

``Strong jobs data could still rekindle expectations the Fed will head for further rate hikes this year,'' said Junya Tanase, a currency strategist in Tokyo at JPMorgan Chase & Co. ``The dollar will remain firm in the coming months.''

The U.S. currency may rise to 125 yen and $1.16 per euro by March 31, Tanase said. The Fed said ``future action would depend on the incoming data.''

The Institute for Supply Management's non-manufacturing index tomorrow may show the services sector is still expanding.

``The market is taking the very superficial view that the Fed is about to stop lifting rates and hence the dollar has weakened,'' said Ashley Davies, a currency strategist at UBS AG in Singapore. ``I'm hesitant to pick this as the start of dollar weakness given that we've still got relatively illiquid trading conditions until next week.''

To contact the reporter on this story: Kabir Chibber in London at kchibber@bloomberg.net ;