FOREX-Dollar set for weekly fall as central banks turn hawkish

(Updates prices)

* Middle East conflict makes central banks cautious

* Euro, yen, sterling gain against dollar as energy prices rise

* Fed not expected to raise rate this year

By Jiaxing Li and Samuel Indyk

LONDON, March 20 (Reuters) - The dollar slipped from multi-month highs this week as soaring energy prices transformed the outlook for global interest rates, leaving the U.S. Federal Reserve the only major central bank that is not expected to raise rates this year.

Before the U.S.-Israeli war on Iran began at the end of February, investors expected two Fed cuts this year. They now believe one is a distant prospect and the outlook for other major central banks has turned even more hawkish. The euro, yen, sterling and Swiss franc headed for weekly gains against the dollar as policymakers laid the groundwork for higher interest rates in response to the war in the Middle East, which has choked oil and gas supplies.

EURO, YEN AND STERLING EDGE HIGHER OVER THE WEEK

"The dollar is suffering on the back of surprising overseas hawkishness, but also from some tentative optimism in energy markets," said ING FX strategist Francesco Pesole.

The euro, albeit slightly weaker on Friday at $1.1572, is up 1.3% for the week. The yen, which trades at 158.47 per dollar, has gained 0.8% and sterling, hovering at $1.3420, is up 1.5%.

Benchmark Brent crude futures are up about 50% since the U.S. and Israel attacked Iran, which has all but closed the Strait of Hormuz and disrupted Middle East energy exports. International crude prices fell sharply from their highs hit on Thursday as global governments work to ease supply disruptions.

EUROPEAN CENTRAL BANK KEEPS RATES ON HOLD The European Central Bank kept rates on hold on Thursday but warned of inflation driven by energy prices. Sources told Reuters policymakers are likely to start discussing hikes next month - a contrast with the Fed's wait-and-see approach. Investors now fully price in a hike by June, while some major banks think next month's policy meeting could see them raise rates.

"The balanced and calm message reiterating downside risks to growth and highlighting that long-term inflation expectations remain anchored argues for the ECB to be unchanged in April," said Kirstine Kundby-Nielsen, FX strategist at Danske Bank.

"But we could see a risk of a rate hike this year if this continues in the Middle East and energy prices continue to rise." The Bank of England also kept rates on hold, but set off one of the sharpest routs yet in short-dated gilts by saying it was ready to act. Markets have priced 63 basis points of hikes by the year's end, implying at least two quarter-point rate rises. Before the war, markets had almost fully priced a rate cut this month. Earlier on Thursday, the Bank of Japan left the door open to a hike as soon as April, wrongfooting investors who had bet on a further slide in the yen - and helping to lift the currency. The Australian dollar was trading just shy of 71 cents on Friday for a weekly gain of 1.5%, after the Reserve Bank of Australia hiked interest rates for the second time in as many months and investors expect there is more to come. The Fed left rates on hold, as expected, earlier this week but Chair Jerome Powell said it was too soon to know the scope and duration of the economic impact from the war.

Money market traders have scrapped their expectations for rate cuts from the Fed this year, but have yet to price in tighter policy, in contrast with other major central banks.

The dollar index was up less than 0.1% on Friday at 99.35 and on track for a 1.1% weekly decline, its largest since late January. Still, many analysts think a prolonged fall is unlikely.

"The longer the war drags on, the higher the U.S. dollar will go, because it will benefit from safe-haven demand arising from higher uncertainty (and) also from the U.S. being an energy exporter," said Carol Kong, currency strategist at Commonwealth Bank of Australia. Crude prices dipped slightly on Friday after U.S. President Donald Trump told Israel not to repeat attacks on Iranian energy infrastructure, after a round of tit-for-tat strikes that crippled the world's largest LNG complex. (Reporting by Samuel Indyk in London and Jiaxing Li in Hong Kong. Editing by Tom Westbrook, Thomas Derpinghaus and Barbara Lewis)