Euro tumbles after ECB's Mersch warns on growth

NEW YORK (Reuters) - The euro fell sharply on Wednesday after a European Central Bank official warned that growth could be slower than expected, increasing fears that U.S. economic weakness may be spreading to Europe.

The euro tumbled nearly two cents against the U.S. dollar after ECB governing council member Yves Mersch told Bloomberg News that the central bank may revise downward its euro zone growth forecasts for 2008, and that the bank should remain flexible with regard to fighting inflation.

The comments triggered a broader recovery in the dollar. The currency has been under increased pressure for the last two weeks as dealers priced in expectations for a half-percentage-point interest rate cut by the Federal Reserve to stimulate a sagging economy this month.

"The concerns about the U.S. are big enough so that (the ECB) is concerned about a future spill over, although it's not real evident in the data yet," Greg Anderson, senior foreign exchange strategist with ABN AMRO in Chicago.

"They are also concerned about the euro possibly going above $1.50 on the back of Fed rate cuts and unchanged policy on their part," he said.

The euro last traded down 0.9 percent to $1.4673 though it was well off the two-week low reached earlier at$1.4596, according to Reuters data. The euro fell 0.5 percent against the yen to 157.17.

Against sterling, the euro sank 0.9 percent to 74.72 pence, on pace for the biggest daily decline in a year.

Mersch's comments threw foreign exchange investors into a frenzy. The euro's decline gained steam as it broke through key technical levels against the dollar and other currencies.

"The ECB's Mersch is throwing a spanner into the euro market," said Brian Dolan, chief currency strategist at Forex.com in Bedminster, New Jersey.

ECB President Jean-Claude Trichet said he still expects the euro zone economy to grow in line with its long-term potential in 2008.

Earlier the dollar had battled after data showed the highest annualized reading of U.S. consumer inflation in 17 years. The flare-up poses a dilemma for the Fed as it attempts to keep the economy afloat.

A dismal reading of December retail sales on Tuesday suggested the U.S. economy might be facing deeper problems, and tumbling stock markets in the United States and around the world fueled market expectations that the Fed will have to get aggressive in lowering borrowing costs.

"If the U.S. proceeds into the recession, the rest of the world has to be affected," said John McCarthy, director of trading at ING Capital Markets in New York. "With equity markets under pressure, risk reduction is the order of the day."

The dollar rose 0.5 percent to 1.0980 Swiss francs, while sterling was largely unchanged at $1.9615.

The dollar climbed 0.4 percent to 107.13 yen after overnight dipping to a 2-1/2-year low of 105.93 yen.

The dollar has dropped around 4 percent against the yen since the year began, as investors dumped risky investments from their portfolios because of volatility in financial markets and fears of a looming U.S. recession.

Lower tolerance to risk has been devastating to carry trades in which cheap borrowing in low-yielding currencies such as the yen and Swiss franc have funded the purchase of higher-yielding currencies.

(Additional reporting by Nick Olivari. Editing by Richard Satran)