WASHINGTON (Reuters) - U.S. consumer spending rose slightly less than expected in July and annual inflation advanced at its slowest pace in more than 1-1/2 years, diminishing expectations of an interest rate increase in December.
Inflation remains stubbornly low even as the labor market is near full employment, a conundrum for the Federal Reserve. Other data on Thursday showed a small increase in new applications for unemployment benefits last week amid a tightening job market.
“The consumer continues to do the heavy lifting when it comes to economic growth,” said Chris Rupkey, chief economist at MUFG in New York. “Inflation is in the slow lane for now and this is likely to make Fed officials cautious on the need to raise rates a third time this year.”
The Commerce Department said consumer spending, which accounts for more than two-thirds of U.S. economic activity, increased 0.3 percent last month after a 0.2 percent gain in June. Economists had forecast consumer spending rising 0.4 percent in July.
The personal consumption expenditures (PCE) price index excluding food and energy edged up 0.1 percent in July. The so-called core PCE price index, which is the Fed’s preferred inflation measure, has now risen by the same margin for three straight months.
The 12-month increase in the core PCE price index dipped to 1.4 percent, the smallest gain since December 2015. The index rose 1.5 percent in the 12 months through June. The annual rate has dropped by half a percentage point since February and the PCE price index has undershot the U.S. central bank’s 2 percent target for the past five years.
The combination of moderate consumer spending and tepid inflation casts doubts on whether the Fed will increase interest rates at its December policy meeting, as most economists expect.
The Fed has raised borrowing costs twice this year. It is, however, expected to announce a plan to start reducing its $4.2 trillion portfolio of Treasury bonds and mortgage-backed securities next month.
“We expect core inflation to get worse on a year-over-year basis before it gets better, making it an easy decision for the Fed to skip raising rates at its September meeting and focus on the balance sheet only,” said Ellen Zentner, chief U.S. economist at Morgan Stanley in New York.
Financial markets are pricing in a roughly 31 percent probability of a rate increase at the Fed’s December meeting, down from about 35 percent earlier, according to CME Group’s FedWatch program.
U.S. stocks were trading higher on the diminishing rate hike prospects, as were prices of U.S. Treasuries. The dollar was flat against a basket of currencies.
The consumer spending report still suggested the economy got off to a strong start in the third quarter after gross domestic product increased at a 3.0 percent annualized rate in the April-June period, the fastest in more than two years.
Growth in the second quarter was buoyed by robust consumer spending. The continuing strength of the labor market should support consumer spending.
In a separate report on Thursday, the Labor Department said initial claims for state unemployment benefits rose by 1,000 to a seasonally adjusted 236,000 for the week ended Aug. 26.
The four-week moving average of claims, considered a better measure of labor market trends as it irons out week-to-week volatility, fell by 1,250 to 236,750 last week, the lowest reading since May.
Claims have now been below 300,000, a threshold associated with a robust labor market, for 130 consecutive weeks. That is the longest such stretch since 1970, when the labor market was smaller.
In July, consumer spending was lifted by a 0.4 percent rebound in personal income after being unchanged in June. Consumers also tapped into savings, which fell to a seven-month low of $510.2 billion from $515.7 billion in the prior month.
While consumers will continue to drive the economy, housing will probably remain a drag.
A third report from the National Association of Realtors showed contracts to purchase previously-owned homes fell in July, the fourth drop in five months. Housing is being hurt by an acute shortage of properties available for sale.
“The latest figures ... come at a time when much of the housing data have turned weaker,” said Daniel Silver, an economist at JPMorgan in New York. “We will likely see the softness in at least some of the housing data persist over the next month or two.”
In a fourth report on Thursday, the Institute for Supply Management-Chicago said its MNI Chicago Business index was unchanged at a reading of 58.9 in August.
Reporting by Lucia Mutikani; Editing by Paul Simao