* Euro near two-month low after of inflation data, bonds rally * European shares sag, commodities lower * Lunar New Year holiday closures curb activity * Dollar loses grip on gains on resurgent yen By Marc Jones LONDON, Jan 31 (Reuters) - The euro fell and the bloc's government bonds rallied on Friday as weaker-than-expected inflation data increased pressure on the European Central Bank to either cut rates or employ other easing tools at its meeting next week. Eurostat's first reading of January inflation showed it slowed back down to 0.7 percent, the level that saw the ECB catch markets off guard with a rate cut in November. The banks sees 2 percent inflation as optimal for the region's economy and with little chance of being anywhere near that level anytime soon, calls have been intensifying on it to take more aggressive action. "It's now more likely than ever that Draghi is going to have to step in with some extraordinary measure to stave off deflation," said Aberdeen Asset Management fixed income investment analyst Luke Bartholomew. "The big challenge is exactly what to do. With the store cupboard of conventional measures largely bare, any policy action is likely to be unprecedented." While more forward-looking data has painted a brighter picture for the euro zone and its debt strained periphery members, unemployment figures, which came alongside the inflation reading, remained at a record high. Whatever form it takes, the prospect of more ECB easing sent the euro lower against its major currency peers and pushed down the all-import money market rates which are the benchmark for borrowing costs in the bloc. The euro was last at $1.3541 against the dollar having started the week at $1.37, while euro zone government bonds which become more attractive the lower borrowing costs go, rallied. Although it is more likely to wait until March when it has new in-house forecasts available, the most obvious option available to Draghi and his fellow policymakers is to take rates even closer to zero, and in the case of the deposit rate that acts as floor for money rates, into negative territory. But they could just as easily increase the amount of cash sloshing around the system by no longer "sterlising" the 170 billion euros of Italian, Spanish and other bonds bought at the peak of the euro crisis. "It should keep speculation on the table that the ECB may have to take further action to help fight disinflation in the months ahead and as such could prove negative for the euro," said Josh O'Byrne, FX Strategist at Citi. SHARED PAIN European shares saw no gain from the data as they struggled to shake off the difficulties that have spread from emerging markets this week. Britain's FTSE 100 and France's CAC 40 extended early losses to 0.7 and 0.9 percent respectively, while Germany's DAX was nursing the biggest falls, dropping 1.3 percent as weaker than expected retail sales and pressure on Deutsche Bank added extra gloom. European banking authorities sketched out some of the details of their upcoming stress tests, saying big banks would have to ensure they still had 5.5 percent in spare capital if another financial meltdown took place. Lunar new year celebrations meant a number of bourses in Asia had been shut, but those that were still open remained weak as fears about the impact of the Federal Reserve's stimulus withdrawal on emerging markets offset the reassurance of Thursday's upbeat U.S. growth data. Japan's Nikkei stock average reversed sharply and ended down 0.6 percent as a resurgent yen, combined with data dousing hopes of more stimulus from the BOJ, left the index with its third worst January in 50 years. For world stocks on MSCI's 45-country, all-world index not only was it the end of their first down month in five, it was also their biggest monthly drop in almost two years. "I think the BOJ is unlikely to adopt additional easing because there is no reason to justify it, given the positive macro-economic environment," said Junko Nishioka, chief economist at RBS Securities. EMERGING TENSIONS In the currency market, the dollar gained the upper hand after the soft euro zone inflation reading while the yen hit a two-month high on the euro. The Turkish lira was also steadier after its torrid week at 2.2570 to the dollar. Political issues in countries such as Turkey, South Africa and Argentina have amplified worries about economic imbalances, hammering their currencies and wiping over a trillion dollars off the value of world stocks this week. Central banks in Turkey, South Africa and India have all reacted by hiking interest rates while Russia's central bank has pledged unlimited foreign exchange interventions to keep the rouble in check. On the commodities front, spot gold was nearly flat at $1,245.00 an ounce, but a 2-percent overnight fall following the strong U.S. GDP data was set to end a five-week rally. Brent oil and U.S. crude hovered at $107.90 and $97.80 a barrel respectively while growth-attuned metal copper drifted toward a 4 percent monthly fall. "The absence of the Chinese market for the next week means that we may see some further downside on commodities, especially if we do see the dollar gaining ground," said Tim Radford, of Sydney-based metals adviser Rivkin.

Source