By Marius and Zaharia
LONDON (Reuters) - The dollar held firm on Wednesday after a surprisingly high reading for U.S. inflation raised expectations that Federal Reserve Chair Janet Yellen could strike a more hawkish tone on the monetary policy outlook.
The risk of a faster U.S. policy tightening was high enough to keep European stocks on the defensive, following earlier falls in many Asian markets. Euro zone bonds were flat.
The U.S. and British central banks' outlooks diverge from that of the European Central Bank, which cut all its interest rates this month, while promising banks more liquidity. The Fed's two-day meeting ends later on Wednesday and will be followed by a news conference with Yellen.
"Markets have been on a hair trigger going into this FOMC meeting partly because of the recent changes of tone from the BoE and ECB. That will mean markets will be reading even more into every word Yellen says than before," said Aberdeen Asset Management Investment Manager Luke Bartholomew.
"If the Fed is more hawkish then the message will be one of divergence from the ECB and the euro will suffer. If the Fed is neutral or dovish then markets will see them as diverging from the Bank of England and so sterling will benefit."
The dollar index was little changed at 80.58, having climbed 0.2 percent on Tuesday. Against the yen, the greenback reached a one-week high of 102.31, while the euro retreated from a one-week peak to trade flat at $1.3558.
U.S. consumer prices recorded their fastest rise in more than a year in May and that may give the Fed a reason to signal it could bring forward the date when it might consider hiking rates.
"We had this number yesterday and it's probably too early to say if it's a trend but certainly ... it's a sign that pressures are starting to pick up a bit," said Kenneth Broux, a strategist at Societe Generale.
The FTSEurofirst 300 index of top European shares was up 0.2 percent at 1,391.00.
Sterling retreated from five-year highs to trade 0.1 percent down on the day at $1.69 after the minutes of the Bank of England's last meeting.
Backing comments last week from Governor Mark Carney that sent the pound soaring, the bank's nine-strong policy committee said it was surprised that markets had priced in a relatively low chance of an interest rate rise in 2014.
But the meeting took place before data, on Tuesday, showing inflation slid to a new five-year low. Members also agreed that, in the absence of inflationary pressures, it would be necessary to see more evidence of economic slack being absorbed before raising rates, the minutes showed.
"This was ... an unsurprising set of minutes which did however paint a picture of a committee which is becoming increasingly divided about the appropriate time for tightening," said Nick Beecroft, senior market analyst at Saxo Capital Markets.
DIVERGING OUTLOOKS
The yield premium offered by U.S.Treasuries over German Bunds was around its highest since 2005 at 125 basis points, highlighting the diverging economic and monetary policy outlooks.
The ECB's stance has kept yields on top-rated bonds depressed and pushed investors towards riskier assets, aiming to maximise returns. Cyprus was on the verge of making the fastest comeback to markets of any bailed-out euro zone country with a new five-year bond on Wednesday.
"We put in a bid not because Cyprus is the soundest creditor in the world but because there's a hunt for yield going on and the bonds will perform," said Guido Barthels, CIO at Luxembourg-based Ethenea.
The looming Fed meeting sent ripples all over the world, with emerging market currencies falling on concerns that higher U.S. yields would make investments in these countries relatively less attractive and potentially hinder their growth prospects.
The Indonesian rupiah hit a four-month low, while Thailand's baht, the Malaysian ringgit and the Philipine peso also fell. Emerging Europe's currencies also held close to multi-month lows to the dollar.
In other markets, Brent crude oil neared $114 per barrel as a strike by Sunni militants on a key refinery near Baghdad stoked worries about oil exports from key producer Iraq.
(Additional reporting by Francesco Canepa and Patrick Graham; Editing by Susan Fenton)
