UPDATE 5-ECB warns of disruptive FX moves, holds policy

* Trichet warns of damage from disorderly currency moves

* Euro breaks through $1.40 before shedding gains

* Sees signs of normalisation in money markets

* Says economic recovery continuing

* ECB holds rates at record low 1 pct

(Updates with details, analyst)

By Marc Jones and Sakari Suoninen

FRANKFURT, Oct 7 (Reuters) - European Central Bank President Jean-Claude Trichet joined an increasingly tense global debate over currencies on Thursday with his strongest warning against market volatility in almost a year.

Trichet told a news conference that sudden swings in foreign exchange were harmful to growth and that exchange rates should reflect economic fundamentals, a pointed reference to countries intervening to keep their currencies low. But he stopped well short of full-blown verbal intervention, eschewing the word "brutal" to describe currency moves -- his favoured expression when relaying displeasure -- and the euro shed earlier gains after briefly spiking during his speech.

How to nip a currency war in the bud will top the agenda for world leaders at the Group of Seven and IMF meetings starting on Friday, where the issue of influencing exchange rates is pitching economically fragile rich nations against faster growing emerging economies.

The economic recovery in the euro zone would continue in the second half of the year, Trichet said, and lower bank demand for ECB liquidity suggested money markets were beginning to function more normally.

That trend has pushed money market interest rates higher and put the ECB on a different path to other major central banks, and analysts expect the rift to add to upward pressure on the euro to appreciate.

The single currency topped $1.40 on Thursday for the first time in eight months -- a level many see as a pain threshold -- but retreated back to $1.3871 by 1650 GMT.

"I think ... excess volatility and disorderly movements in exchange rates have adverse implications for economic and financial stability," Trichet said.

YUAN REVALUATION CALL

The ECB and European governments have shown little sign of action to cap its recent gains, in contrast to policies in Japan, China and the United States which have led to warnings of a "currency war" in competitive devaluations.

Trichet called for China to stick to its plans to let the renminbi appreciate and said it and other emerging economies should move towards free-floating currencies in the medium to longer term, and called for verbal U.S. support for the dollar.

Japan intervened to weaken the yen last month and this week cut interest rates to zero. The U.S. Federal Reserve is also poised to loosen monetary policy further. The ECB kept its interest rates on hold at 1.0 percent on Thursday.

Last November, many politicians saw a threat to recovery in the strength of the euro. The single currency has gained 18 percent against the dollar since June but is still some way below the peaks it scaled late last year.

Analysts said the ECB was clearly feeling frustrated.

"The ECB is getting concerned because Asian central banks are not freeing up their exchange rates and the euro is breaking the brunt of the dollar weakness," said Stephen Gallo from Schneider Foreign Exchange.

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For graphic of euro zone liquidity levels click:

http://r.reuters.com/wer86p

For graphic of ECB government bond purchases click:

http://r.reuters.com/zeq88n

For a Breakingviews column-Euro will stay high as Trichet

longs for exit, click [ID:nLDE6961QS]

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MODEST RECOVERY

The ECB's decision to keep interest rates at 1.0 percent came as no surprise -- all 79 economists in a Reuters poll had predicted it would leave rates on hold. The median forecast is for no change until the fourth quarter of next year. [ECB/INT]

The central bank also kept its assessment of the euro-zone economy unchanged, seeing growth continuing, but warning of continued uncertainty.

Turning to the money markets, Trichet said last week's move by banks to slash their use of European Central Bank loans showed money markets were beginning to function more normally.

This development has been "interpreted by the market, I would say rightly so, as an element of proof of normalisation, of progressive normalisation", he said.

Banks borrowed far less than expected at ECB lending operations last week, suggesting more banks are able to access markets for funding and stirring speculation the ECB may roll back support sooner rather than later in 2011.

The drop in excess cash in the interbank system has pushed money market interest rates up to their highest in 14 months, but Trichet denied this had any implications for monetary policy. [ID:nEAP000437]

The ECB last month extended its unlimited lending policy until at least January and it is not expected to make any formal decisions on exiting these measures before December.

Analysts said it was too early to pick the ECB's next moves and debate would continue for a while.

"Trichet hinted that there is a healthy discussion within the Governing Council on how the pace of the exit strategy will need to be adjusted," Unicredit economist Marco Annunziata said in a note.

(Editing by Mike Peacock, John Stonestreet)