Dollar gains on oil plunge and Fed's inflation-focus

Pedestrians walk past a bank's currency exchange centre in Seoul July 10, 2008.

NEW YORK (Reuters) - The dollar climbed to seven-week peaks against the euro and a major currency basket on Tuesday, as oil prices plunged and the Federal Reserve maintained its focus on quelling persistent U.S. inflation pressure in the economy.

The dollar briefly pared gains against the euro and yen immediately after the decision, which kept rates steady at 2 percent. Investors were disappointed that there was only one dissenter to the Fed decision, with Dallas Fed President Richard Fisher opting for higher rates.

Markets were expecting Philadelphia Fed President Charles Plosser to dissent as well because of an onslaught of tough comments on inflation over the last few weeks.

Overall, the dollar kept its bid tone. Analysts said Tuesday's Fed statement was more balanced than what the market had expected, as it expressed concern about both economic growth and inflation.

"The (Fed) statement does not point to one clear rate path," said Dustin Reid, director of forex strategy at ABN AMRO in Chicago. "Clearly, the statement continues to focus quite a bit on upside inflation risks, but the reintroduction of downside growth risks coupled with the 10-1 vote gives the doves/(dollar) bears more leverage." he added.

In late trading in New York, the euro was down 0.7 percent on the day at $1.5461 having traded as low as $1.5448, the lowest since June 16, according to Reuters data.

The ICE Futures U.S. dollar index, which measures the U.S. currency's performance against a basket of six currencies, climbed as high as 73.990 .DXY, its highest since mid-June. It last traded up 0.6 percent at 73.936.

Following the Fed decision, prospects for the U.S. central bank to increase benchmark rates by 25 basis points in September fell as low as 24 percent from 34 percent earlier. The first quarter-point rate increase by the Fed is not priced until a rate-setting meeting in January, although a rate increase in December is still 90 percent priced in.

OIL DROP BOOSTS DOLLAR

The drop in oil helped ease fears that high energy prices will continue to weigh on the U.S. economy at a time consumer prices are showing an unexpectedly fast rise. Oil's continued weakness has underpinned the dollar in recent weeks.

Oil fell to a three-month trough of $118 per barrel while metals and other commodity prices dropped further as concerns over slowing global demand sparked profit-taking. It last traded down 2.3 percent at $118.60 per barrel.

Gold, a natural hedge against inflation, sank 2.2 percent to 874.10 per ounce. So far this month, gold has dropped more than 4 percent.

"Despite the Fed and the ECB meetings this week, oil is really becoming the short-term focus in the foreign exchange markets," said Omer Esiner, a currency analyst at Ruesch International in Washington, D.C. "It is really helping push the dollar up."

Interestingly though, the Fed made no mention of the recent weakness in commodity prices, except by saying that "earlier increases" in commodity prices have resulted in higher inflation and inflation expectations.

Marco Annunziata, chief economist at Unicredit Markets and Investment Banking in London, said it may be too soon to tell whether commodity prices have indeed corrected. But he agreed with the Fed's decision to keep the statement "balanced", confirming his view "the Fed is looking for the right time to start normalizing rates."

Earlier in the session, data showed the U.S. service sector shrank slightly in July but by less than economists had expected. Analysts said the report added to a growing body of evidence in recent weeks that the U.S. economy was more resilient than many initially had thought.

The Australian dollar, meanwhile, was among the weakest performers on Tuesday, falling to a four-month low at US$0.9134. The Reserve Bank of Australia kept interest rates at 7.25 percent on Tuesday but sent a strong signal it will ease soon amid tighter credit conditions and slowing demand. The Aussie dollar was down 1.4 percent at US$0.9158.

(Additional reporting by Vivianne Rodrigues; Editing by James Dalgleish)