Oil falls more than $3 as U.S. Fed warns on inflation

By Richard Valdmanis

HOUSTON (Reuters) - Oil fell more than $3 a barrel on Tuesday after the U.S. Federal Reserve issued a rare warning on the inflationary risk posed by a weak dollar, suggesting the central bank is not likely to cut interest rates further this year.

The move added to a steep sell-off since last month's peak over $135 a barrel amid mounting worries that high prices may dent global energy demand and that increased regulatory scrutiny could cool speculation.

"In short, the commodity complex's 'all clear to buy' signal has just been flicked off and I am sure traders are on high alert for a rebound in the dollar, a bearish event for commodities," said Chris Jarvis, senior analyst at Caprock Risk Management in New Hampshire.

U.S. crude settled down $3.45, or 2.7 percent, to $124.74 a barrel after earlier hitting a low of $123.87. London Brent crude fell $3.44 to $124.58 a barrel.

Dealers said Federal Reserve Chairman Ben Bernanke's comments warning that a weak dollar could worsen inflation, pushed the market lower by feeding a recovery in the U.S. currency and dimming the prospects of a new rate cut.

Weakness in the greenback had been one factor driving investment in energy, agriculture and metals by encouraging the buying of dollar-denominated commodities as a hedge against inflation.

"Bernanke seems more concerned about inflation than growth and for the first time that I remember, he brings the weak dollar into the macro picture by linking rising import costs -- inflationary -- to the front page," said Tom Sowanick of Clearbrook Financial.

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