* Euro wallows at two-week lows after sharp drop overnight
* Unexpected slowdown in inflation sparks ECB rate cutexpectations
* Euro seen under pressure ahead of Nov 7 ECB meeting
* Dollar main gain if upcoming US ISM data positive
* Aussie holds above 2-week low after decent China data
By Hideyuki Sano and Ian Chua
TOKYO/SYDNEY, Nov 1 (Reuters) - The euro dropped to atwo-week low on Friday after a surprise slowdown in euro zoneinflation sparked speculation the European Central Bank may takeaction to bolster the economy.
Euro zone inflation dropped to a four-year low of 0.7percent in October, compared to a forecast of a flat reading at1.1 percent, and way under the ECB's target of just below 2percent.
"It should mean quite a lot for the ECB that inflation fellbelow 1 percent. The slowdown in inflation does not seem to beover yet," said Sho Aoyama, senior market analyst at MizuhoSecurities.
"They know Japan's experience of deflation and that oncedeflation takes hold, it could take decades to get out of it.The ECB may not cut rates next week but it will imply it isready to do so," he added.
The euro fell to as low as $1.35385, its lowest since Oct.17, and last stood at $1.3554, down 0.3 percent on theday, after having fallen 1.1 percent the previous day.
The currency is now flirting with important chart supportsaround $1.3550, including a level representing the 76.4 percentretracement of its Oct 16-25 rally and a 38.2 percentretracement of its rally since Sept.
The euro looks set to stay under pressure until the ECB'snext policy meeting on Thursday as other euro zone data alsoshowed unemployment held at record highs in September, andincluded alarming revisions to previous months.
The common currency also lost ground against othercurrencies including the yen, hitting a two-week low of 132.985yen.
Renewed pressure on the euro saw the dollar index rising toa two-week high of 80.418, pulling further away from anine-month trough of 78.998 plumbed a week earlier.
The dollar, however, eased against the yen, dipping 0.2percent to 98.14 yen to be off this week's peak of 98.69,largely in a knee-jerk risk-off reaction to fall in U.S. andJapanese shares.
Still, in contrast to the euro zone, U.S. data was far moreencouraging. Business activity in the U.S. Midwest surged pastexpectations in October as new orders hit their highest levelsince 2004, while weekly unemployment claims fell, counteringrecent evidence of soft economic growth.
The strong Chicago survey has fuelled speculation thenational ISM survey of manufacturing, due later on Friday, couldalso surprise to the upside.
The upbeat data only served to keep alive some expectationsthe Federal Reserve might scale back stimulus at its Decembermeeting, though most analysts still tip March as the window fora move.
The Australian dollar managed to hold above Wednesday'stwo-week low of $0.9441 after two Chinese manufacturing surveysposted decent readings.
The final HSBC/Markit Purchasing Managers' Index (PMI)showed China's giant manufacturing sector grew at its fastestrate in seven months in October. China's official PMI releasedearlier in the day put manufacturing growth at 51.4, the highestin 18 months.
The Aussie stood flat on the day at $0.9460.
- Budget, Tax & Economy