* ECB holds rates at record low 1 percent
* Trichet warns of damage from disorderly currency moves
* Sees signs of normalisation in money markets
* Says economic recovery continuing
(Updates with Trichet quotes, details, analyst)
By Marc Jones and Sakari Suoninen
FRANKFURT, Oct 7 (Reuters) - Sudden swings in foreign exchange rates pose a threat to economic growth, European Central Bank President Jean-Claude Trichet said on Thursday after the ECB kept rates on hold at 1.0 percent.
In his strongest comments on currency volatility in almost a year, Trichet said exchange rates should reflect economic fundamentals, a pointed reference to countries intervening to keep their currencies low. The central bank head also predicted economic recovery in the euro zone would continue in the second half of the year and said 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. Analysts expect the rift to add to upward pressure on the euro to appreciate.
"I think that exchange rates should reflect economic fundamentals, that excess volatility and disorderly movements in exchange rates have adverse implications for economic and financial stability," Trichet told a news conference.
His comments failed to stop the euro from gaining ground. It topped $1.40, the highest level in eight months, while he spoke, and was trading at $1.3945 by 1450 GMT.
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 policy further.
Currency rates will be a hot topic at the Group of Seven and IMF meetings starting on Friday, where the issue of whether and how nations should influence exchange rates is pitching rich nations against mostly emerging economies in Asia and Latin America.
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.
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.
This time, 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.
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.
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.
The central bank also kept its assessment of the euro zone economy unchanged, seeing growth continuing, but warning of continued uncertainty.
"The recovery should proceed at a moderate pace in the second half of this year with the underlying momentum remaining positive," Trichet said.
"At the same time, uncertainty is still prevailing."
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, adding to a growing trend over the past month, 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.
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.
"We consider that it is still necessary, taking into account the fact that the market is not functioning correctly, at least until now," Trichet said. (Editing by Mike Peacock)