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* Euro hits 3-week high amid talk of ECB rate hike
* Mixed U.S. inflation data clouds interest rate outlook
* Credit fears, high oil adds to unease, uncertainty
By Vivianne Rodrigues
NEW YORK, May 20 (Reuters) - The dollar fell on Tuesday as talk of higher euro zone interest rates prompted investors to increase exposure to the euro, though losses were capped by inflation data that muddied the U.S. interest rate outlook.
Concern about further credit-related losses and their impact on financial markets also sent the dollar tumbling against the low-yielding yen and Swiss franc, while a record high in oil added to fears about surging price pressures.
That has led to choppy trading conditions, with prices whipping around for most of the global session.
"It's been difficult to trade, as volumes have been fairly light, but the main driver has been interest rate expectations moving in the euro's favor again," said Benedikt Germanier, senior currency strategist at UBS in Stamford, Connecticut.
The euro rose earlier to a three-week high of $1.5679 <EUR=> after an adviser to the German government said the European Central Bank may soon raise interest rates. It last traded at $1.5663, up 1 percent from late Monday.
The remarks from Wolfgang Franz, the president of the ZEW economic research institute, offset the second straight monthly decline in the ZEW's investor sentiment survey and dovetailed with a separate report showing German producer price inflation at a 20-month high.
"The inflationary pressures in Europe are relentless and that's driving the euro higher, and the slowdown is relatively mild," said Boris Schlossberg, senior currency strategist at DailyFX.com in New York.
Sterling rose 1 percent to $1.9684 <GBP=>, while the dollar fell 0.7 percent to 103.62 yen <JPY=> and 1.6 percent to 1.0358 Swiss francs <CHF=>, with analysts pointing to concern about the credit crunch.
Meredith Whitney, a U.S. banking analyst at Oppenheimer & Co, said the crisis would extend into 2009 and beyond, setting up three years of multibillion-dollar revenue losses.
There was little reaction in currency markets to the Bank of Japan's decision to keep its borrowing costs on hold at 0.50 percent, as expected, on Tuesday. [ID:nT37919]
The ECB has held its benchmark rate at 4 percent since last June as record oil prices have pushed inflation higher. The Federal Reserve, by contrast, has slashed rates from 5.25 percent to 2 percent since September but has since signaled a pause in its rate-cutting campaign.
Tuesday's data on U.S. producer prices complicated the outlook. Overall prices advanced less than expected, but core inflation, which strips out volatile food and energy prices, rose by a larger-than-expected 0.4 percent.
"The situation with inflation is just very serious and shows no sign of abating any time soon," said Lena Komileva, head of G7 Market Economics at Tullett Prebon.
Fed Vice Chairman Donald Kohn said on Tuesday that rates seem to be at the right level to support growth without boosting inflation. But he added that officials must be ready to adjust rates quickly if the outlook changes.
"Kohn sounded more neutral than dovish to me, and with a falling dollar and rising oil prices, (higher) inflation expectations are a risk, and they need to monitor that closely," Germanier said.
Crude surged to a new record above $129 CLc1 on Tuesday, boosted partly by the weak dollar and fears that high global demand will strain supplies.
Schlossberg said a strong reading on Wednesday in the Ifo survey of German business sentiment could push the euro back toward all-time highs above $1.60. (Additional reporting by Steven C. Johnson; Editing by Jonathan Oatis)