NEW YORK (Reuters) - The dollar fell to eight-and-a-half-month lows against the euro and a currency basket on Friday on expectations the Federal Reserve will delay scaling back monetary stimulus on the heels of this month's political battles over the U.S. budget.
Analysts said concerns about the negative impact on the U.S. economy and the likelihood the Fed would leave its bond-buying programme intact until well into next year would weigh on the dollar, giving the euro the potential to rise towards $1.40.
"The real economy has been negatively impacted by the government shutdown and uncertainty of the debt crisis, all of which pushes out eventual Fed policy normalization which is bad for the dollar," said Omer Esiner, chief market analyst at Commonwealth Foreign Exchange in Washington, D.C.
The dollar index, which measures the dollar's value against a basket of currencies, fell to 79.478, its lowest since early February. It last traded at 79.563, down 0.1 percent.
The euro rose to $1.3703 against the dollar, its highest since early February when it touched its 2013 peak of $1.3711. It was last at $1.3692, up 0.1 percent on the day and up 1.1 percent for the week, its best week since September 20.
A little over a month ago, analysts were convinced the Fed was ready to embark on the first step of reining in five years of ultra-loose monetary policy for the world's biggest economy.
But the Fed unexpectedly left policy unchanged in September. This was followed by a partial 16-day halt in U.S. government spending in October, then a deal over the debt ceiling which leaves scope for further wrangling over the budget early next year.
"Expectations for tapering have been pushed out and that will be negative for the dollar ... The trend is definitely pointing towards $1.40 for the euro," said Niels Christensen, currency strategist at Nordea in Copenhagen.
Analysts at Citi also said the euro could move closer to $1.40 in the near term due to the expected delay in the Fed reducing stimulus. They expect the euro to be bought "as a safe haven and reserve proxy for the dollar".
The dollar index was down around 1 percent on the week and on track for its biggest weekly decline since the week of September 20, which came after the surprise Fed decision.
"The market will come round to the idea that tapering is off the agenda until the back end of Q1 or even Q2, and that is a powerful dollar negative," said Paul Robson, currency strategist at RBS in London.
The deal reached on Wednesday funds the U.S. government only until January 15 and raises the borrowing limit through February 7.
The first wave of U.S. data released on Thursday after the government returned to work was fairly upbeat. But the main focus is on the September payrolls report, which the Labor Department said will be published on Tuesday.
The dollar also struggled against the yen after a fall in U.S. bond yields undermined the U.S. currency's allure.
It was down 0.1 percent on the day at 97.77 yen, below a three-week high of 99 reached on Thursday. The dollar has lost 0.8 percent against the yen this week, the worst week since September 27.
But one-month dollar/yen implied volatilities fell to a nine-month low, which analysts said reflected expectations that the dollar was likely to remain within its recent trading range between 96.50 and 99 yen.
The Australian dollar rose to a four-month high, helped by data showing China's annual economic growth quickened to 7.8 percent in the third quarter. [ID:nL3N0I80A8] It last traded at $0.9666, up 0.4 percent.
Reporting by Nick Olivari; Editing by James Dalgleish