Dollar hits nine-month low versus yen as Fed debate reignites

By Harry Robertson, Ankur Banerjee

LONDON/SINGAPORE (Reuters) -The dollar fell on Friday to its lowest level this year against the Japanese yen after media reports reignited the debate about an outsized Federal Reserve rate cut next week.

The U.S. currency fell 1% to 140.36 yen, the lowest since late December, and last traded 0.7% lower at 140.87. The euro, pound and Swiss franc made gains against the dollar.

U.S. economic data this week appeared to support the case for a typical 25 basis point (bp) cut next week, with the measure of consumer price inflation that strips out volatile food and energy prices rising more than expected in August.

However, market analysts said reports by the Wall Street Journal and Financial Times saying a 50 basis point cut is still an option, and comments from a former Fed official arguing for an outsized cut, caused a shift in market expectations.

"A couple of articles were published in the Wall Street Journal and the FT suggesting that a 50 bp move was still in play, which has led markets to once again re-evaluate their expectations," said Henry Allen, macro strategist at Deutsche Bank.

"That was something of a surprise to investors, who had been increasingly pricing in 25 bps, not least after the core CPI (inflation) print was a bit stronger than expected on Wednesday."

Traders were assigning a roughly 40% chance of a 50 bp cut by the Fed next Wednesday, up from around 25% on Thursday and 15% on Wednesday, according to money market pricing.

Former New York Federal Reserve President Bill Dudley said on Friday there was a strong case for a 50 bp cut, arguing rates were currently 150-200 basis points above the so-called neutral rate for the U.S. economy, where policy is neither restrictive nor accommodative. "Why don't you just get started?" he said.

The euro was last up 0.11% at $1.1086 after rising 0.57% on Thursday after the European Central Bank cut interest rates by 25 bps but ECB President Christine Lagarde dampened expectations for another cut next month.

Expectations that interest rates will be higher than previously expected tend to boost a currency by making fixed income assets in the country or region more attractive, and vice versa.

The euro "is eyeing $1.11 again after the combined support of a not-dovish-enough European Central Bank and rising dovish bets on the Fed," said Francesco Pesole, currency strategist at ING.

The dollar index, which tracks the currency against six peers, was 0.1% lower at 101.06.

Sterling was little changed at $1.3119, around its highest in a week. The Bank of England is expected to hold interest rates at 5% next week after kicking off easing with a 25 basis point reduction in August.

The dollar fell 0.51% against the Swiss franc, which like the yen is particularly sensitive to expectations about Fed policy and U.S. bond yields.

Investors were also looking to the Bank of Japan's interest rate decision next Friday, where it's expected to keep rates steady at 0.25%.

BOJ board member Naoki Tamura said on Thursday the central bank must raise rates to at least 1% as soon as the second half of the next fiscal year but added that it would likely raise rates slowly and in several stages.

(Reporting by Harry Robertson in London and Ankur Banerjee in Singapore; Editing by Sonali Paul, Susan Fenton, William Maclean)