FOREX-Grim jobs data, ECB rate hike talk pummel dollar

(Recasts, updates prices, changes byline)

* Dollar drops as May U.S. jobless rate jumps to 5.5 pct

* Dollar set for worst weekly loss vs euro since late March

* ECB officials toughen interest rate hike talk

By Lucia Mutikani

NEW YORK, June 6 (Reuters) - The dollar fell on Friday as an unexpected surge in the U.S. jobless rate revived fears of a deeper and more prolonged economic downturn, diminishing the prospects of Federal Reserve interest rate hikes by year-end.

At the same time, European Central Bank officials appeared to leave little doubt that euro zone rates were set to rise next month, helping to set up the dollar for its worst weekly loss versus the euro since late March.

Pressure on the embattled U.S. currency was also added by the dramatic jump in oil prices to record highs. There are fears that soaring oil prices could further damage the U.S. economy, while simultaneously fanning inflation.

"The data today revealed that the glass is half empty for the U.S. economy," said Brian Dolan, chief currency strategist at Forex.com in Bedminster, New Jersey.

"The outlook has been wavering between a mild and relatively brief downturn and now we have a shot of economic reality that suggests it's going to be a longer and deeper downturn," he added.

The New York Board of Trade's dollar index, which tracks the dollar's performance versus a basket of currencies, dropped to 72.362 .DXY, the lowest in more than two-weeks.

The euro climbed to a session peak of $1.5773 EUR=, on track to post its best weekly gain versus the dollar since late March. It traded at $1.5759 late Friday, up 1.1 percent on the day.

ECB President Jean-Claude Trichet sparked a euro rally on Thursday when he flagged a July interest rate hike to quell inflation pressures. Trichet's remarks trumped Fed Chairman Ben Bernanke's attempt to talk up the dollar two days earlier.

RATE SPREADS MOVE AGAINST DOLLAR

"Interest rate spreads since the ECB announcement yesterday have moved against the dollar. The basic takeaway from all this is confusion from what the Fed initiated on Tuesday to what the ECB did on Thursday," said Dolan.

"We will have to see another round of verbal action from the United States in order to shore up (dollar) sentiment."

On Friday, ECB officials reinforced Trichet's message about possible tighter monetary policy after the central bank kept its key refinancing rate at 4 percent.

U.S. crude oil futures CLc1 jumped more than $10 per barrel to over $138 per barrel, sending stocks on Wall Street .DJI .SPX .IXIC tumbling around 3 percent. The drop in equities pushed the dollar lower versus the yen and Swiss franc.

The yen and Swiss franc tend to attract flows during periods of uncertainty as the countries' low interest rates reflect the capital surplus of their respective countries.

Against the yen, the dollar fell 0.8 percent to 105.10 yen JPY=, pushing away from a high of 106.33 yen touched in overnight trade. The dollar dropped as low as 1.0191 Swiss francs CHF=, the weakest in six weeks.

It last traded at 1.0195 Swiss francs, down 1.8 percent.

A government report showed the U.S. economy shed jobs for a fifth straight month and the unemployment rate jumped to 5.5 percent in May from 5.0 percent in April as more people from stressed households entered the job market.

Short-term interest rate futures, which track market expectations for Fed policy, reduced the chances for a Fed rate hike by October to about 56 percent from as high as 82 percent earlier.

The chances of the Fed leaving rates unchanged at 2 percent this month were fully priced in. The fed funds rate target has been slashed by 3.25 percentage points since mid-September.

"There is a greater risk of another cut in the second half of the year from the Fed despite the fact that Bernanke has already indicated seemingly in his comments that the Fed is on hold for the near term," said David Powell, currency strategist at Bank of America in New York.

"This in itself is not justifying another cut, but the continued deterioration in data is making a cut look more likely despite the increased inflationary worries of the Fed." (Additional reporting by Gertrude Chavez-Dreyfuss; Editing by James Dalgleish)