FOREX-Dollar slides after benign U.S. inflation data

* Low U.S. inflation adds to economic recovery story

* Dollar falls against euro, hits two-week lows vs yen

* U.S. current account narrows in first quarter (Recasts, adds comment, updates prices)

By Gertrude Chavez-Dreyfuss

NEW YORK, June 17 (Reuters) - The dollar weakened against the euro and yen on Wednesday as an unexpectedly small rise in U.S. inflation strengthened expectations that the Federal Reserve will keep interest rates low for some time.

The expectations on stable interest rates was a relief to investors worried about a recent surge in Treasury yields, which has raised fears that higher rates could clip an economic recovery.

The data also cut demand for dollars as a safe haven.

Traders, however, said the currency market's optimism was cautious at best, and sentiment could turn quickly on any bad piece of economic news.

"We're seeing dollar weakness because the idea is that inflation is not pretty evident right now and that is seen as a positive in terms of the growth outlook and risk appetite," said Brian Dolan, chief currency strategist at Forex.com in Bedminster, New Jersey.

Data on Wednesday showed U.S. consumer prices rose just 0.1 percent in May despite higher gasoline costs, and had the biggest decline over the past 12 months since 1950. For story, click on [ID:nN17329915].

In midday New York trading, the euro rose 0.3 percent against the dollar to $1.3871 EUR=EBS on electronic trading platform EBS.

The dollar fell to roughly two-week lows against the yen to 95.53 JPY=EBS and was last at 95.58 yen, down 0.9 percent on the day.

The ICE Futures' dollar index .DXY was also lower, trading 0.1 percent weaker at 80.650.

A report that the U.S. current account deficit narrowed in the first quarter added to optimism in the currency market, even though the deficit topped market expectations. The current account gap of $101.1 billion was the smallest shortfall since the fourth quarter of 2001. [ID:nN16397991]

DOWNWARD TREND IN U.S. CURRENT ACCOUNT

"The current account is clearly trending downwards as domestic demand slows," said Ian Shepherdson, chief U.S. economist at High Frequency Economics in Valhalla, New York. "The speed of the decline has been helped by the drop in oil prices" in the second half of last year.