The dollar fell on Friday after a tame measure of core U.S. inflation reinforced market expectations that the Federal Reserve may be nearing the end of its two-year-long monetary policy tightening cycle.

The 'core' U.S. PCE index, the inflation gauge most closely watched by Fed policymakers, rose moderately and was in line with consensus forecast. Core prices strip out volatile energy and food costs.

We're seeing a continuation of dollar bearishness that's in line with the Fed's much more dovish stance, in the sense that inflation pressures are not escalating but moderating, said Boris Schlossberg, senior currency strategist, at Forex Capital Markets in New York.

That's why we see euro-dollar mounting the $1.2750 level, he added.

Rate futures pegged chances of another Fed rate increase in August at roughly 65 percent, down from about 81 percent before the Fed's rate decision on Thursday.

The Fed raised benchmark overnight lending rates by a quarter percentage point for the 17th successive time, to 5.25 percent on Thursday, as expected, but dampened prospects of another interest rate increase in August, saying current easing in U.S. economic growth should stem inflation pressures.

The euro rose to a three week-high against the dollar at $1.2772 before trading back down to $1.2768, still up 0.8 percent.

A generally upbeat consumer confidence survey put out by the University of Michigan and lower than expected U.S. Midwest business activity gauge did little to change negative sentiment on the dollar, analysts said.

Ron Simpson, director of currency analysis at Action Economics in Dobbs Ferry, New York, said Thursday's Fed statement still weighed on the dollar and therefore there has been marginal reaction from the latest batch of economic data.

The dollar has been on a roll to the downside and we've seen some follow-through selling into the long weekend, Simpson said. He added though that the market is going to dry out pretty quickly and we would see some position-squaring ahead of the July 4 holiday weekend.

Financial markets are closed on Tuesday, July 4, for the Independence Day holiday, while trading sessions on Monday would be limited.

In contrast to the market's negative sentiement on the dollar, the euro is seemingly on an uptrend, boosted by prospects of faster euro zone rate hikes.

Investment bank JP Morgan on Friday said it had changed its forecast for euro zone interest rates, and now expects the European Central Bank to raise interest rates on July 6.

The bank sees rates in the euro zone rising to 4 percent by early 2007 from 2.75 percent now.

The dollar fell 0.6 percent against the yen to 114.32 yen. Against the Swiss franc, the dollar fell 0.8 percent to 1.2260 francs. Sterling was up 1 percent at $1.8456.

High expectations that the Fed could raise rates to 5.5 percent at its next policy meeting in August had pushed the dollar to two-month highs against major currencies in the past week. But the currency lost all its gains on Thursday after the Fed's economic outlook statement failed to support that view. (Additional reporting by Toni Vorobyova in London and Steven C. Johnson in New York)