Dollar retreats, weighed down by fall in US inflation

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The dollar slid on Wednesday, as a surprise decline in U.S. inflation last month tempered expectations that the Federal Reserve would raise interest rates at this week's monetary policy meeting.

The greenback had traded higher before the U.S. data, underpinned by lofty U.S. Treasury yields in the wake of upbeat consumer spending data on Tuesday.

But the unexpected 0.1 percent decline in U.S. consumer prices in August, the first since January, wiped out the dollar's gains.

As a result, rates futures traders lowered bets on a potential interest rate increase on Thursday. Following the inflation data, traders placed just a 21 percent chance that the U.S. central bank would end its near-zero interest rate policy on Thursday, down from 27 percent late on Tuesday, according to CME Group's FedWatch program.

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Rates futures also indicated a 39 percent chance of rate increase in October, from 42 percent on Tuesday.

"The Fed is still well short of the inflation half of its dual mandate...and because of this, market participants have more or less priced out the possibility of a September rate hike," said Christopher Vecchio, currency analyst at DailyFX in New York.

In late trading, the dollar index was down 0.2 percent at 95.402, nowhere near the highs of 96.616 hit in early September. Still, the index was off a two-week low struck on Monday, on doubts about whether the Fed will hike rates.

The euro was slightly up at $1.1275, gaining ground after earlier losses triggered by soft euro zone inflation numbers. The euro zone inflation report kept alive expectations that the European Central Bankwould extend quantitative easing in coming months.

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The dollar was up 0.2 percent against the yen at 120.62 yen, with the Japanese currency largely shrugging off a lowering of Japan's sovereign credit rating by Standard and Poor's.

Earlier, two-year Treasury yields reached their highest in more than four years and long-dated U.S. yields their highest in nearly two months ahead of the two-day Fed meeting that starts on Wednesday.

The rise in two-year yields widened the spread between U.S. and German government bonds to its highest in eight years, initially helping the dollar recover.

Volumes were on the low side, with most investors preferring to stay on the sidelines before the Fed decision.