* Dollar index recoils from 7-month highs
* Yen in limbo as market looks to "new" BOJ
* Sterling jumps as market covers large short positions
* Euro off 3-month low but seen vulnerable
By Hideyuki Sano
TOKYO, March 15 (Reuters) - The rally in the dollar paused on Friday as sterling enjoyed a short squeeze and the yen was propped up by profit-taking in the U.S. currency after Japan's parliament approved new leadership at the Bank of Japan, as expected.
The dollar index eased slightly to 82.533, further retreating from a seven-month peak of 83.166 hit the previous day, though it is up nearly 5 percent from its Feb. 1 trough of 78.918.
Japan's parliament approved Prime Minister Shinzo Abe's nominee for central bank governor, Haruhiko Kuroda, and nominees for the two deputy governor posts, clearing the way for radical monetary easing Abe has long pressed for.
But the yen did not budge much for now as hopes for fresh easing were offset by short-covering in the Japanese currency from one way bets against the yen in the past few months.
The dollar fetched 96.03 yen, almost flat from late U.S. levels. The currency pair has been trapped in a narrow trading range since it scaled a 3-1/2-year peak of 96.71 on Tuesday, as many investors looked to the BOJ's next steps.
"What the BOJ will do should set the dollar/yen's future trading range for a long time. The range could be 86-96 yen (if the BOJ disappoints), in which case, we are now near the top of the range. Or it could be 95-105 yen," said Takako Masai, head of forex at Shinsei Bank in Tokyo.
Kuroda's pledge to "act with speed" and do whatever it takes to hit the BOJ's new inflation target has some investors speculating he may summon a meeting even before the next scheduled policy review on April 3-4. They will take over the current leadership on March 20.
Analysts suspected the greenback could continue to gain ground, particularly against the yen, sterling and euro as the U.S. economy outperforms.
Data showing a fall in the number of Americans filling new claims for employment benefits was the latest in a string of data painting a brighter outlook for the world's biggest economy.
If that continues, it is likely to fuel market speculation of when the Federal Reserve will start to slow its asset buying and give dollar bulls a reason to get really excited.
"The exit debate will heat up in the second half of the year," said Sebastien Galy, a strategist at Societe Generale.
"The U.S. economic outperformance and the fears of a not-too-distant Fed exit imply that the dollar is no longer a funding currency of choice in the carry trade."
The dollar's rally was curbed, however, also as the British pound surged as investors scrambled to cover short positions made on expectations of more quantitative easing by the Bank of England.
Bank of England Governor Mervyn King said the bank was not seeking a further depreciation in sterling and that the currency was now properly valued.
Traders also said the pound could have been helped by sovereign buying and media reports about Qatar planning to invest billions of pounds into key infrastructure projects in Britain.
The move in sterling gathered momentum as buy-stops were tripped, driving the currency up more than 1 percent on Thursday, its biggest daily gains in over seven months.
The pound last traded at $1.5090,, slightly above late U.S. levels and well off a 33-month trough of $1.4832 set earlier in the week.
The euro bounced to $1.3010, also slightly up from late New York trade and well above a three-month trough of $1.2911 set on Thursday, partly cheered by solid demand for Spanish long-term bonds at an auction.
Still in addition to concerns over the sluggish euro zone economy, political instability in Italy could hamper the currency as the new Italian parliament convenes on Friday for the first time after inconclusive elections late last month.