LONDON, Jan 5 (Reuters) - The euro hit three-week lows against the dollar on Monday, with weaker than expected Italian and Spanish inflation data and tax cuts in Germany seen heaping pressure on the European Central Bank to cut interest rates further soon.
Sharp losses for the euro, which has shed more than 3 cents in the European session so far, also spread to the euro/sterling pair -- taking it well away from record lows for the pound reached last week and easing momentum towards parity.
A slightly less hesitant attitude to risk helped lift stock market sentiment and the dollar to its highest in more than three weeks against the yen.
Figures on Monday showed Italian EU-harmonised consumer prices fell 0.2 percent month-on-month in December, slowing to growth of 2.3 percent year-on-year from 2.7 percent in November [ID:nL5155007].
Spain's EU-harmonised inflation tumbled to a 10-year low of 1.5 percent in December, adding evidence that price pressure in the euro zone may be easing [ID:nL549831].
"We've seen inflation falling in Italy and Spain and that just confirms what we would expect to see in the euro zone flash numbers tomorrow which will be sub-2 percent," said Jeremy Stretch, markets strategist at Rabobank in London.
"The inflation picture is changing and that will have important implications for potential estimations of what the ECB might do," he added.
By 1224 GMT, the euro <EUR=> had fallen 2.1 percent on the day to $1.3603, having earlier hit $1.3594 -- its lowest since mid-December, according to Reuters data.
The euro also fell heavily to 93.63 pence <EURGBP=> against the pound -- pulling the battered UK currency back from recent record lows near the brink of parity.
Economists polled by Reuters expect euro zone inflation figures, due on Tuesday, to show that prices rose 1.8 percent in December year on year compared with a rise of 2.1 percent previously ECON.
Meanwhile German Chancellor Angela Merkel bowed to pressure to include tax relief in a new stimulus package designed to shield the economy from its worst recession since World War Two.
BIG ECB RATE DECISION
The European Central Bank meets next week to decide on interest rates in the single currency bloc, amid a fast changing inflation backdrop, with markets largely pricing in a chance of rates being cut 50 basis points to 2 percent.
Markets also see the probability of borrowing costs falling more sharply to 1.75 percent ECBWATCH.
"It will be important to closely monitor what (ECB President Jean-Claude) Trichet has to say in the next few days. The fundamental case for easing policy by at least another 50 basis points in January is strong," Brown Brothers Harriman & Co said in a note to clients.
Adding fuel to euro area rate expectations, ECB Vice President Lucas Papademos said on Sunday that more interest rate cuts may be needed to shield the euro zone economy from recession [ID:nN04347375].
The dollar gained traction against the yen as a 1.5 percent rise in European shares .FTEU3 hit the Japanese currency, which has benefited from falling stock prices in past months, and helped to push the dollar to its strongest against a basket of currencies and the euro since mid-December.
The dollar <JPY=> climbed 1.2 percent to 93.39 yen according to Reuters data, its highest since early December.
The dollar index .DXY, measuring it against a basket of six major currencies, rose to 83.011, its strongest since Dec. 15. (Reporting by Veronica Brown; Editing by Stephen Nisbet)
Thomson Reuters journalists are subject to an Editorial Handbook which requires fair presentation and disclosure of relevant interests.
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