* Weak euro zone inflation data spur view on more ECB action
* Dollar index records best monthly gain in 8 months
* Yen best G7 performer in January amid emerging market jitters
* Canadian dollar falls to 4-1/2 year low on sluggish growth
By Richard Leong
NEW YORK, Jan 31 (Reuters) - The euro fell on Friday as soft euro zone inflation data rekindled concerns the European Central Bank may have to act to combat deflation, while the dollar strengthened on mildly encouraging data to close out its best month since May.
Nagging worries about emerging market woes spreading underpinned safe-haven buying for the yen, which was on track to be the best performer among G7 currencies in January.
“The focus on the euro is that we could see a policy response from the ECB next week,” said Shaun Osborne, chief foreign exchange strategist at TD Securities in Toronto.
Euro zone inflation data on Friday showed a surprise drop to 0.7 percent year-on-year in January. Analysts had expected a rise to 0.9 percent.
The fall could be a trigger for further easing by the ECB, which holds its policy review next week, to sustain a fragile recovery and ward off a falling price spiral that could cripple the economy for years.
The euro fell 0.4 percent against the dollar at $1.3498 after touching its lowest level since late November.
The single currency also hit a two-month trough against the yen, last down 0.8 percent against the Japanese currency at 138.14 yen.
For January, the euro fell 1.8 percent against the dollar for its biggest monthly drop in 11 months, while it shed 4.8 percent against the yen, its steepest monthly decline against that currency since July 2012.
Trading volumes were light with large parts of Asia on holiday for the Lunar New Year.
Meanwhile, risk aversion hit commodity-related currencies, with the Canadian dollar falling to a 4-1/2-year low. The loonie last traded 0.3 percent lower at C$1.1126 per dollar in the wake of weaker-than-expected data on Canadian growth in November.
The selloff in the euro and emerging market currencies like the Turkish lira and South African rand this week has benefited the yen - last year’s weakest major currency - as the dollar fell 0.3 percent to 102.35 yen on Friday, retracing from an earlier low of 101.78 yen.
There were large month-end option expiries at 102.25 and 103 yen, according to one trader.
Another boost to the yen was Japan’s core consumer price inflation, which accelerated to 1.3 percent in January, the highest level in five years.
The dollar index, which measures the dollar against six major currencies, rose 0.26 percent to 81.25, still helped by the prior day’s solid reading on U.S. fourth-quarter gross domestic product, which revived hopes that the global economy could, on the whole, take troubles from emerging markets in stride.
The dollar index rose 1.3 percent in January, its biggest monthly gain since May.
Friday’s data on U.S. consumption, Midwest manufacturing and consumer sentiment reinforced the notion the world’s biggest economy has some cushion to weather the emerging markets turmoil and reduced stimulus from the Federal Reserve.
“The dollar has emerged from this tapering better than we had thought,” TD’s Osborne said.
The greenback might strengthen further in the near term as traders anticipate January U.S. payrolls data would improve from their stunningly weak levels in December.
“The U.S. dollar should be biased toward the upside next week before the payrolls data,” said Joe Manimbo, senior market analyst at Western Union Business Solutions in Washington.
Emerging market central banks could buy back dollars, said Adam Cole, head of G10 FX strategy at RBC Capital in London.
“If you’ve seen intervention to support their currencies, then they’d be recycling to replenish dollars (that they’d spent propping up their own currencies).”
Fed data released late Thursday hinted some foreign central banks sold their Treasuries holdings to raise cash and buy their own currencies on the open market in a bid to stabilize them from further damage due to emerging market jitters.
Overall foreign holdings of securities such as Treasuries, mortgage-backed securities and agency debt at the U.S. central bank fell by $20.77 billion to $3.325 trillion in the week ended Wednesday, led by a $20.66 billion drop in Treasury holdings. It was the largest weekly decline for both since June, the Fed data showed.