Dollar up; Traders focus on higher rate outlook

NEW YORK, Sept 27 (Reuters) - The dollar rallied on Tuesday, hitting 2-month highs against the euro and yen, as traders focused on remarks from Federal Reserve officials that point to more interest rate increases. Analysts said one catalyst for dollar gains during the session were remarks by San Francisco Fed President Janet Yellen, who said the Federal Reserve "must deliver" on its commitment to price stability, adding that an unacceptable rise in inflation is not an option. "We are getting a consistent view from the Fed now that they are somewhat worried about the risk of a higher inflation rate. That is going to cause more rate hikes to come and higher yields will help the dollar," said Tim Mazanec, senior currency strategist with Investors Bank & Trust in Boston. Yellen's remarks overshadowed a report showing a steep fall in U.S. consumer confidence, and a speech by Federal Reserve Chairman Alan Greenspan on "economic flexibility" delivered by satellite to an economics conference in Chicago. Many traders had hoped he would bolster expectations of higher interest rates, but he failed to deliver. Instead, the dollar eased back from these 2-month highs in afternoon trading. The euro was down about 0.5 percent from late Monday at $1.2013, according to Reuters data. It had gone as low as $1.1979 Against the Japanese yen, the dollar was trading up about 1 percent at 113.27 yen. It had climbed as high as 113.50 yen. Higher U.S. interest rates support the dollar because they increase the allure of dollar-denominated deposits to foreign investors. The euro had already slipped moderately even after a weak U.S. consumer confidence report although investors were largely waiting for Yellen and Greenspan to speak. The Conference Board's September Consumer Confidence reading was 86.6, well below analysts' forecasts of 95.0, reflecting a blow to consumer confidence from hurricane damage on the U.S. Gulf Coast and spikes in energy prices. A separate report showed August U.S. new home sales were at an annualized rate of 1.237 million, below forecasts of 1.340 million. But Todd Elmer, currency strategist with Citigroup in New York, said "New home sales were not a big number for the currency market."

Later in the day investors were buoyed by Yellen but disappointed by Greenspan, analysts said. Greenspan said that asset prices "invariably" fall after long periods of big risk-taking in markets, and a flexible economy is better able to withstand the inevitable blow. He added that it was "simply not realistic" to rely on policy-makers to spot and deal with speculative bubbles. "He doesn't say anything very specific about current monetary policy," said Steven Englander, Chief North American Foreign Exchange Strategist at Barclay's Capital in New York. "In some ways for FX markets, which have got used to Fed speakers being relatively hawkish, this may be a little disappointing (for the dollar)." Against the Swiss franc, the dollar was up 0.5 percent to 1.2957 francs. Sterling was down 0.7 percent to $1.7667. The Fed raised overnight rates last week for an 11th straight time to 3.75 percent. Although the central bank said Hurricane Katrina's damaging blow to the economy would not pose a "persistent threat," it repeated that more "measured" monetary tightening was needed. Analysts said U.S. companies' repatriation of profits from Europe before the end of the July-September quarter was also helping the dollar this week. They get a much-reduced tax rate for repatriating overseas profits this year. The dollar was also supported by the growing interest rate differential between U.S. Treasuries and German Bunds, with the 10-year yield spread testing six-year highs.