FOREX-Dollar set for weekly drop as central banks turn hawkish with rising oil prices

* Middle East conflict makes central banks cautious

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

* Investors pare expectations for Fed rate cuts (Updates headline and prices throughout, adds analyst comment)

By Chibuike Oguh and Samuel Indyk

NEW YORK/LONDON, March 20 (Reuters) - The dollar gained on Friday but was still headed for a weekly fall against major currencies as investors pared back bets on interest rate cuts from the U.S. Federal Reserve given the likelihood of higher inflation from rising energy prices.

Before the U.S.-Israeli war on Iran began in late February, investors had priced in two Fed cuts this year. But they now largely believe one cut is a distant prospect, and other major central banks are turning 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.

The euro was down 0.25% to $1.156 but on track to add 1.3% this week.

The yen was down 1% against the greenback to 159.30 per dollar. It is set to gain 0.24% this week.

Sterling weakened 0.72% to $1.333 but was set to gain nearly 0.84% against the dollar for the week.

"The overall picture is still that central banks sound more confident (about the impact of inflation) than people thought, especially the Bank of England and the Bank of Japan as well," said Juan Perez, director of trading at Monex USA in Washington.

"This followed a message from the Federal Reserve on Wednesday that is tied to the idea that everyone has been thinking that there's going to be one or two cuts for 2026 and they have no interest in cutting rates."

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. Brent futures for May delivery settled on Friday up 3.26% to $112.19 a barrel, the highest since July 2022.

The dollar index was up about 0.26% at 99.59, but on track for a 0.94% weekly decline, its largest since late January. Still, many analysts think a prolonged fall is unlikely.

"Markets have preempted communication with a notable shift in policy pricing: many G10 central banks now priced for hikes, while the Fed is priced for fewer cuts in 2026. This repricing has mitigated some of the USD's oil-induced rally," said Bank of America Global Research analysts led by Adarsh Sinha.

CENTRAL BANK DECISIONS

The European Central Bank kept rates on hold on Thursday, but warned of inflation driven by energy prices.

The Bank of England also kept rates on hold, but set off a sharp rout in short-dated gilts by saying it was ready to act.

The Bank of Japan left the door open to a hike as soon as April, wrong-footing investors who had bet on a further slide in the yen and helping to lift the currency.

The Australian dollar weakened 0.99% versus the greenback to $0.702 for a weekly gain of 0.53%, after the Reserve Bank of Australia hiked interest rates for the second time in as many months on Tuesday and investors expected 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.

The Swiss franc was flat at 0.788 against the dollar but headed for a weekly gain of 0.43%.

(Reporting by Samuel Indyk in London and Jiaxing Li in Hong Kong. Editing by Jan Harvey, Nia Williams and Chris Reese)