By Elizabeth Howcroft

LONDON (Reuters) -The dollar strengthened on Friday and was on track for a weekly gain as investors waited for U.S. inflation data to set the currency’s direction.

The U.S. dollar has fallen in April and May so far, reaching its lowest in more than four months, but has changed course this week, picking up in a move which analysts said was due to month-end flows.

The United States and Britain have a public holiday on Monday.

The dollar index picked up in the late Asian and early European session, trading up 0.1% on the day at 90.142 at 1109 GMT .

Versus the yen, the dollar hit a seven-week high. The pair changed hands at 109.935, with analysts noting Japan’s rise in unemployment and fall in consumer prices. Japan extended its state of emergency in Tokyo and other areas by about three weeks, as the COVID-19 pandemic shows no signs of easing. [nL3N2NE5AM][nL2N2NF007]

CENTRAL BANKS

Currency market participants are focused on the outlook for inflation and central bank monetary policy.

The European Central Bank struck a dovish tone this week, slowing the euro’s momentum ahead of the policy meeting on June 10.

The euro was down 0.1% at $1.2178, compared to the four-month high of $1.2266 it hit earlier in the week.

The New Zealand dollar, which earlier in the week jumped on the prospect of an interest rate hike by September 2022, was down 0.7% at 0.72425.

The Australian dollar was down 0.4% at 0.77105. Analysts are eying the Reserve Bank of Australia as a possible next central bank to turn hawkish.

The British pound was down 0.2% at around $1.41680, on track for its best month versus the dollar so far this year.

A Bank of England policymaker said on Thursday that the central bank could raise interest rates as soon as the first half of next year, but is more likely to wait until later in 2022.

In the United States, the number of people filing new claims for unemployment benefits dropped more than expected last week, data on Thursday showed.

Core personal consumption expenditures data — an inflation report closely watched by U.S. central bankers — is due at 1230 GMT.

“Inflation will determine the pace of the Fed policy normalization,” wrote Bank of America strategists in a note to clients.

“The market is already pricing QE tapering to begin next year and rate hikes the year after. Therefore, inflation is what could really surprise markets, leading to a faster tightening once the Fed starts.”

YUAN STRENGTH

China’s onshore yuan hit a new three-year high, passing the key 6.40 level to reach 6.3675 versus the dollar.

Kenneth Broux, FX strategist at Societe Generale, said the fact that the yuan has been stronger than 6.40 for three days is a turning point in Chinese policy.

“Markets seem to be obsessed with inflation, and we’ll probably get another very high print in the US today, but really I think the story has been what is China up to,” he said.

“Nobody thought that the central bank would allow the yuan to strengthen beyond 6.40 and they have.”

“If it is the case that they let the Chinese yuan strengthen that would be very positive for the global economy.”

President Joe Biden is set to release his first full budget since taking office in January later in the session. The New York Times reported on Thursday that Biden will seek $6 trillion in federal spending for the 2022 fiscal year.

“The market has yet to focus on the legacy of the pandemic in terms of deficits,” wrote ING strategists in a note to clients.

“Driving FX markets have been re-opening stories and whether central banks feel comfortable in discussing monetary normalization plans. Yet today should see some focus on US deficits.”

In cryptocurrencies, bitcoin was down around 7% at $35,800 while ether was down 9% at around $2,490.

(Reporting by Elizabeth Howcroft, Editing by William Maclean and Chizu Nomiyama)