FOREX-Euro falls on soft price data, dollar set for best month since May
* Weak euro zone inflation data spur view on more ECB action
* Dollar index poised for best monthly gain in 8 months
* Emerging market jitters, Japanese inflation boost yen
* Canadian dollar falls to 4-1/2 year low on sluggish growth
NEW YORK, Jan 31 (Reuters) - The euro fell on Friday as soft euro zone inflation data rekindled concerns the European Central Bank may have to act to combat deflation, while the dollar strengthened on mildly encouraging data to close out its best month since May.
Nagging worries about emerging market woes spreading underpinned safe-haven buying for the yen.
"The focus on the euro is that we could see a policy response from the ECB next week," said Shaun Osborne, chief foreign exchange strategist at TD Securities in Toronto.
Euro zone inflation data on Friday showed a surprise drop to 0.7 percent year-on-year in January. Analysts had expected a rise to 0.9 percent.
The fall could be a trigger for further easing by the ECB, which holds its policy review next week, to sustain a fragile recovery and ward off a falling price spiral that could cripple the economy for years.
The euro fell 0.5 percent against the dollar at $1.3484 after touching its lowest level since late November.
The single currency also hit a two-month trough against the yen, last down 0.9 percent against the Japanese currency at 137.97 yen.
The euro is on track to suffer its biggest monthly drop versus the dollar in 11 months and the steepest monthly decline against the yen since July 2012.
Trading volumes were light with large parts of Asia on holiday for the Lunar New Year.
Meanwhile, risk aversion hit commodity-related currencies, with the Canadian dollar falling to a 4-1/2-year low. The loonie last traded at C$1.1176 per dollar in the wake of weaker-than-expected data on Canadian growth in November.
The sell-off in the euro and emerging market currencies like the Turkish lira and South African rand this week has benefited the yen - last year's weakest major currency - as the dollar fell 0.6 percent to 102.08 yen on Friday.
There were large month-end option expiries at the 102.25 and 103 yen, according to one trader.
Another boost to the yen was Japan's core consumer price inflation, which accelerated to 1.3 percent in January, the highest level in five years.
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The dollar index rose 0.2 percent to 81.23, helped by solid U.S. October-December growth numbers, which revived hopes that the global economy could, on the whole, take troubles from emerging markets in stride.
The dollar index has risen more than 1 percent in January and is poised for its biggest month gain since May.
Friday's data on U.S. consumption, Midwest manufacturing and consumer sentiment reinforced the notion the world's biggest economy has some cushion to weather the emerging markets turmoil and reduced stimulus from the Federal Reserve.
"The dollar has emerged from this tapering better than we had thought," TD's Osborne said.
There was also talk in the market that emerging market central banks may buy back dollars.
"That is a possibility," said Adam Cole, head of G10 FX strategy at RBC Capital in London. "If you've seen intervention to support their currencies then they'd be recycling to replenish dollars (that they'd spent propping up their own currencies)."
Data from the Federal Reserve late Thursday hinted some foreign central banks sold their Treasuries holdings to raise cash and buy their own currencies on the open market in a bid to stabilize them from further damage due to emerging market jitters.
Overall foreign holdings of securities such as Treasuries, mortgage-backed securities and agency debt at the U.S. central bank fell by $20.77 billion to $3.325 trillion in the week ended Wednesday, led by a $20.66 billion drop in Treasury holdings. It was the largest weekly decline for both since June, the Fed data showed.
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