The dollar dropped on Thursday after Federal Reserve Chairman Ben Bernanke told a congressional committee that more interest rate cuts may be necessary and that the U.S. economic outlook has worsened.
In testimony before the House of Representatives' Budget Committee, the Fed chief echoed a bleak assessment of the economy's health he delivered last week, widely seen as a signal that the U.S. central bank would slash rates by a hefty half-percentage point at month's end.
Separately, a survey showed factory activity in the U.S. Mid-Atlantic region contracted dramatically in January, reinforcing fears of recession.
"When the head of a central bank says there may be need for additional action, the writing is already on the wall," said David Watt, senior currency strategist at RBC Capital Markets
in Toronto. "That means it's still a bearish dollar environment."
Late morning in New York, the dollar was lower against the yen, though it was well off the session low of 106.61.
Bernanke also threw his support behind efforts to craft a fiscal stimulus package.
"Fiscal action could be helpful in principle, as fiscal and monetary stimulus together may provide broader support for the economy than monetary actions alone," Bernanke said in remarks prepared for delivery to the U.S. House of Representatives Budget Committee.
Putting further pressure on the dollar, the Philadelphia Federal Reserve Bank said its business activity index took a huge dive to minus 20.9 in January from minus 1.6 in December.
Economists polled by Reuters had forecast a slight uptick to minus 1.0. Any reading below zero indicates contraction in the region's manufacturing sector.
"It just confirms what we all think that the U.S. economy is rapidly spiraling toward recession," said Greg Salvaggio, senior vice president of capital markets at Tempus Consulting in Washington.
As well as being helped by the weaker dollar, the euro was bolstered by comments from European Central Bank President Jean-Claude Trichet on Thursday.
"It is absolutely clear that a solid anchoring of inflation expectations is really paving the way for a long-term high level of growth," Trichet told a conference on growth hosted by
the ECB and the Bank of France.
The euro overnight had already rebounded from two-week lows against the dollar after comments from European Central Bank Governing Council member Yves Mersch suggested the bank was not looking to cut interest rates yet.
It was already a volatile session in currency markets before Bernanke with the yen rallying against the dollar to session highs after worse-than-expected results from Merrill Lynch reignited investors' risk aversion.
The euro hit a session low 156.42 yen, down more than half a percent on the day as the results reached investors, before recovering slightly.
Elsewhere sterling rose versus the euro and dollar after John Gieve, deputy governor of the Bank of England, said inflation is likely to rise well above target in the coming months.
Sterling has come under pressure in recent weeks as weak data led to increased expectations of a Bank of England rate cut, but Gieve's comments shifted investors'focus to inflationary pressures that could limit the extent of monetary policy easing.
Sterling was last up versus the dollar. Euro/sterling was down.
Investors will watch for any developments in Washington over a possible stimulus package for the struggling economy that President George W. Bush has said he is considering.
The White house said Bush will hold a conference call with congressional leaders on Thursday to discuss the economy.