* US PPI undershoots, adds to signs of easing inflation

* Markets price out July Fed interest rate hike

* Oil prices inch higher, war-induced inflation lingers

By Jiaxing Li

HONG KONG, July 16 (Reuters) - The U.S. dollar hovered near

a one-month low on Thursday, as soft inflation data reinforced

bets that the Federal Reserve can stay patient on interest rate

hikes, while escalation in Middle East hostilities added upside

risk to the inflation outlook.

The greenback slipped against the Japanese yen for the third

trading session, by 0.1% to 162.075 yen. The euro

was 0.1% higher at $1.1472, its strongest in a month.

Sterling held near a two-month high at $1.354 on

market expectations that Britain's incoming prime minister will

pick a fiscally conservative finance minister.

The Australian and New Zealand dollars

were both down about 0.1%, at $0.6995 and $0.5842 respectively.

The U.S. dollar index, which tracks the currency

against six peers, was little changed at 100.47, hovering near

its lowest since June 18. It has fallen 0.8% over the previous

two sessions and is on track for a weekly decline.

U.S. producer prices unexpectedly fell in June, in their

biggest decline in 14 months, adding to evidence that inflation

was easing before the latest flare-up in the Middle East.

The data, together with surprisingly soft consumer inflation

and a slowdown in job growth in June, effectively rule out a Fed

interest rate increase this month.

Chances for a hike in July were slashed to 11%, versus a 45%

implied probability at the start of the week. Markets still see

even odds of at least a 25 basis-point increase in September,

according to Fed funds futures prices via CME Group.

"The recent dollar weakness appears to be a correction from

previous highs. Markets had aggressively priced in a July rate

hike, which now looks somewhat overblown given that inflation is

cooling fast," said Bosco Wu, investment strategist at Bank of

East Asia.

However, the tightening trajectory is intact as one month of

cooling data is unlikely to signal sustained inflation slowdown,

and the flare-up in the Middle East should limit downside for

the greenback, Wu said.

The escalation in hostilities between the U.S. and Iran kept

oil prices near one-month highs, maintaining pressure on the

inflation outlook.

The U.S. struck Iran's coastal defences and missile sites on

Wednesday after re-imposing a naval blockade of its ports, while

Iran threatened to shut off more regional energy exports, saying

it was engaged in an "existential war" with America.

Oil prices rose for a fourth consecutive day on Thursday,

with Brent crude futures last trading near a one-month high at

$85.28 a barrel.