* Euro pares losses on hawkish ECB Mersch comments
* Libya violence fuels risk aversion, helps USD, CHF
* New Zealand dollar suffers after earthquake
(Adds comment, details, updates prices)
By Jessica Mortimer
LONDON, Feb 22 The euro was steady versus the dollar on Tuesday as hawkish comments from a European Central Bank official helped it pare earlier steep losses as escalating tensions in Libya prompted investors to seek safer assets.
Risk aversion gripped markets, lifting the dollar and the Swiss franc, after the defiance of Libyan leader Muammar Gaddafi in the face of a mounting public revolt stoked uncertainty and prompted a supply cut in one of the world's major oil exporters. [ID:nLDE71L0ER]
The euro, which had earlier fallen as much as one percent against the dollar, cut its losses, however, after ECB policymaker Yves Mersch was quoted saying the central bank may have to adjust its language on inflation. [ID:nWEB0672]
The ECB's Nout Wellink was also quoted expressing concerns about inflation. [ID:nWEB0708]
These comments followed recent hawkish rhetoric from various ECB officials, including policymakers Juergen Stark and Lorenzo Bini Smaghi, which have highlighted the prospect of the ECB raising interest rates sooner than previously thought.
However, analysts said any further escalation of troubles in Libya or the Middle East could quickly encourage investors to resume cutting exposure to riskier assets.
"There has been a sharp rally in euro/dollar on the Mersch comments which caught the market the wrong way round, but it looks overdone," said Ankita Dudani, G10 currency strategist at RBS.
"Events in the Middle East and Libya are definitely on everyone's radar and markets are becoming very wary of risk.
The euro EUR= was steady at $1.3673, well above an earlier low of $1.3527.
The dollar was up 0.1 percent at 77.727 against a currency basket .DXY, but it was well below the day's high of 78.326.
The Swiss franc was broadly firmer, with the euro EURCHF= down 0.7 percent at 1.2864 francs, having earlier dropped as low as 1.2793 francs, its weakest since late January.
Markets also become more risk-averse on news of an earthquake that rocked New Zealand's second biggest city and sent the New Zealand dollar to a near two-month low against its U.S. counterpart. [ID:nL3E7DM055]
The euro cut losses against the yen, trading slightly up on the day at 113.75 yen EURJPY=R.
OIL PRICE RALLY
Oil prices rallied to 2 1/2-year highs on fears the unrest in Libya could spread to other major Middle East oil producers.
Higher oil prices are seen weighing on global growth, particularly in emerging countries heavily dependent on oil and commodity imports. Rising prices have already led to higher inflation, which can threaten vulnerable economies.
However, analysts said any sign of a calming of the situation could see the focus in FX markets switch back to interest rate differentials.
"If the region stabilises and tensions don't spread beyond Libya, and if there is a perception the region is going to be under control ... I think we will return to the risk-on, monetary policy-driven trade," said Audrey Childe-Freeman, head of EMEA FX strategy at JPMorgan Private Bank. <^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^
Graphic on market reactions to Libya turmoil:
Big moves in the spot market cranked up implied volatility in major currencies, with euro one-week vols jumping above 11 percent EUR1WO=R.
The New Zealand dollar NZD=D4 tumbled more than 2 percent on the day to $0.7469, its weakest since late December. It was last down 1.6 percent at $0.7509.
Market participants said the currency extended losses after Westpac Bank said New Zealand's central bank may cut rates to shore up confidence, adding that a rate cut may occur at or before a policy meet next month. [ID:nSYA008335]
(Additional reporting by Naomi Tajitsu; editing by Stephen Nisbet)