By Kevin Plumberg
NEW YORK, Jan 16 (Reuters) - The euro fell sharply on Wednesday after a European Central Bank official warned that growth in the 13-nation region could be slower than expected, fanning fears that U.S. economic weakness may be spreading to Europe.
The euro plummeted nearly 2 cents against the U.S. dollar after ECB Governing Council Member Yves Mersch told Bloomberg News that he did not rule out a downward revision of euro zone growth forecasts for 2008, and that the bank should remain flexible with regard to fighting inflation.
The comments also triggered a broader recovery in the dollar. The currency has been under increased pressure for the last two weeks as dealers priced in expectations for a half-percentage-point interest rate cut by the Federal Reserve to stimulate a sagging economy.
However, as futures markets reflected increased expectations for lower euro zone interest rates this year, the dollar rebounded.
"The concerns about the U.S. are big enough so that (the ECB) is concerned about a future spillover, although it's not real evident in the data yet," said Greg Anderson, senior foreign exchange strategist with investment bank ABN AMRO in Chicago.
"They are also concerned about the euro possibly going above $1.50 on the back of Fed rate cuts and unchanged policy on their part," he said.
The euro <EUR=> last traded down 1 percent from late Tuesday to $1.4673, though it was well off the two-week low reached earlier at $1.4596, according to Reuters data. The euro fell 0.2 percent against the yen to 157.60 <EURJPY=>.
Against sterling, the euro sank 0.9 percent to 74.70 pence <EURGBP=>, on pace for the biggest daily decline in a year.
Mersch's comments threw foreign exchange investors into a frenzy. The euro's decline gained steam as it broke below key technical levels against the dollar and other currencies.
"The ECB's Mersch is throwing a spanner into the euro market," said Brian Dolan, chief currency strategist at Forex.com in Bedminster, New Jersey.
ECB President Jean-Claude Trichet later said he still expects the euro zone economy to grow in line with its long-term potential in 2008. For details, see [ID:nL16860467].
Earlier, the dollar had struggled after data for 2007 showed the highest annual reading of U.S. consumer inflation in 17 years. The flare-up poses a dilemma for the Fed as it attempts to keep the economy afloat while keeping inflation in check.
A dismal reading of December retail sales on Tuesday suggested the U.S. economy might be facing deeper problems, and tumbling stock markets in the United States and around the world fueled market expectations that the Fed will have to get aggressive in lowering borrowing costs.
"If the U.S. proceeds into the recession, the rest of the world has to be affected," said John McCarthy, director of trading at ING Capital Markets in New York. "With equity markets under pressure, risk reduction is the order of the day."
The New York Board of Trade's U.S. dollar index climbed 0.6 percent, mostly because of the decline in the euro, to 76.248 .DXY.
The dollar rose 0.6 percent to 1.0990 Swiss francs <CHF=>, well above an all-time low of 1.0839 francs plumbed earlier, while sterling was largely unchanged at $1.9627 <GBP=>.
The dollar jumped 0.7 percent to 107.45 yen <JPY=> after overnight dipping to a 2-1/2-year low of 105.93 yen.
The dollar has dropped around 3.5 percent against the yen since the year began, as investors dumped risky investments from their portfolios because of volatility in financial markets and fears of a looming U.S. recession.
Lower tolerance of risk has been devastating to carry trades in which cheap borrowing in low-yielding currencies such as the yen and Swiss franc have funded the purchase of higher-yielding currencies. (Additional reporting by Nick Olivari; Editing by Jonathan Oatis)