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NEW YORK (Reuters) - The euro fell against the dollar for the first time in five sessions on Friday, receding from the previous day's seven-week high, as participants questioned how close policymakers are to coming up with a plan to tackle the European debt crisis.
The single currency shared by 17 countries pared losses after central bank sources told Reuters the European Central Bank is considering setting yield band targets under a new bond-buying program to let it keep its strategy shielded and avoid speculators trying to cash in.
The euro had earlier fallen to a session low against the dollar after Market News International reported senior euro-zone officials as saying the German Finance Ministry is seriously considering a plan in which Greece would be obliged to ask for a temporary exit from the euro zone until it sorts out its public finances.
Overall, however, it has been a banner week for the euro. Speculation that the ECB will unveil plans to help lower Spanish and Italian bond yields at its next policy meeting on September 6 caused the euro to rally from $1.2333 a week ago to trade above $1.25.
"This was a very good week for tail risk, with talk of the ECB buying bonds and Wednesday's Fed minutes both being risk positive," said Steven Englander, head of G10 strategy at CitiFX, a division of Citigroup in New York.
"Having said that, with shorts being taken out and longs added, the euro's upside is limited from here because market positioning is not as favorable," he said.
The euro last traded at $1.2534, down 0.2 percent and below Thursday's peak of $1.2589, its highest since early July. Despite Friday's losses, it has gained 1.7 percent this week, its best weekly performance on a percentage basis since February 26 at current prices.
CitiFX's Englander said the euro's bounce this week will likely not grow into a trend reversal higher.
"Whatever the theoretical promise of ECB bond buying proposals, implementation setbacks could limit the positive impact of concerted peripheral bond buying by the ECB, the EFSF (European Financial Stability Facility) and, when ratified, the ESM (European Stability Mechanism)."
Also limiting the euro's upside is that euro growth should remain weak and Citi's economists do not think that QE3 is a done deal in the near term, he said.
Minutes released this past week from the last Federal Open Market Committee meeting, the Federal Reserve's policy making arm, raised the prospect that the Fed may embark on a third round of quantitative easing to boost the economy.
The Federal Reserve has room to deliver additional monetary stimulus to boost the U.S. economy, Fed Chairman Ben Bernanke told a Congressional oversight panel in a letter obtained by Reuters on Friday.
Bernanke at the end of next week will give a closely watched speech at an annual symposium in Jackson Hole, Wyoming, which will be closely watched for clues into the prospect of further bond-buying from the Fed.
Another round of quantitative easing would be negative for the dollar as it is tantamount to printing money and dilutes its value.
The euro rose to a seven-week high on Thursday after sources told Reuters that Spain is in talks with euro-zone partners over conditions for aid to bring down its borrowing costs, though the country has not made a final decision to request a bailout.
But Soraya Saenz de Santamaria, Spain's deputy prime minister, on Friday denied the country was in talks with the euro zone over financial assistance.
"The critical thing is to control interest-rate costs for Italy and Spain," said Boris Schlossberg, managing director of FX strategy at BK Asset Management in New York, after news of the yield-band targets. "A band, I think, does two things: It allows them flexibility not to commit to a specific level, and it allows them to achieve policy goals with a minimum of capital expenditure. And it should spook speculators."
After the ECB meeting on September6, there are Dutch elections and a German Constitutional Court ruling on the euro-zone rescue fund on September 12 and an EU finance ministers' meeting starting on September 14.
The dollar was last up 0.2 percent at 78.54 yen, according to Reuters data.
Additional reporting by Nick Olivari; Editing by Chizu Nomiyama