FOREX-Dollar falls as US growth

LONDON, Sept 5 (Reuters) - The dollar hit its lowest levels in nearly four months on Monday on worries that the Federal Reserve may pause in its dollar-supportive monetary tightening as the United States counts the cost of Hurricane Katrina. The yen rose both against the dollar and euro, taking heart from buyoant Tokyo stocks which hit 4-year highs and data showing Japanese firms boosted capital spending in the second quarter. In relatively thin trading due to the U.S. Labour Day holiday, investors sold dollars as surging gasoline prices and uncertainty about how deeply Katrina has affected the economy fanned talk the Fed might not raise interest rates at its Sept. 20 meeting from the current 3.5 percent. "People are unwinding growth expectations and interest rate expectations," said Naeem Wahid, currency strategist at HBOS Treasury Services. "The market was pricing in Fed funds rate at 4.25 percent by the year end at one point, now it has been pushed back to 3.75 percent. The dollar will struggle in this environment." By 0940 GMT, the dollar had fallen 1 percent on the day to to 108.77 yen, a 2-1/2 month low. Against the euro it stood at $1.2556, holding close to Friday's 3-month low of $1.2589. It hit a four-month low versus sterling at $1.8499 and a 3-1/2 month low of 1.2241 Swiss francs. The dollar hit its lowest level since May 18 against a basket of major currencies. The euro showed little reaction to data showing growth in the euro zone service sector eased in August, with high oil prices putting pressure on margins. FED PAUSE? The big question for investors is how the Fed will respond to Katrina's impact. U.S. Treasury Secretary John Snow said on Friday that Katrina could slow U.S. economic growth for a quarter or so, though it would not have a lasting impact. Some economists said that it would take evidence of a severe downturn in the economy for the Fed to take an extended break in its credit tightening cycle that started in June 2004, given their stated concerns about inflation pressures. The Fed has raised its funds rate 10 straight times to 3.50 percent, helping propel the dollar higher during the first half of the year. "The market is increasingly seeing a risk that the Fed pauses in its rate cycle -- not only that but also the peak in the interest cycle will be considerably lower," said Adam Cole, senior currency strategist at Royal Bank of Canada. The market will keep an eye on upcoming data on U.S. retail sales, jobless claims and consumer confidence, as well as reaction from Fed officials who are due to speak this week, for clues about the hurricane's impact on policy. "I personally think they would raise rates (this month). Inflation could be also a problem so the key to this would be Fed speakers this week," said Wahid at HBOS.