Tame U.S. inflation bolsters Fed caution on rate hikes

Snow rests on the eagle statue atop the U.S. Federal Reserve in Washington January 26, 2016. REUTERS/Jonathan Ernst

By Lucia Mutikani

WASHINGTON (Reuters) - U.S. inflation barely rose in March as consumer spending remained tepid, making it less likely that the Federal Reserve will be able to follow through on its projected two interest rate increases this year.

The tame inflation backdrop was reinforced by another government report on Friday showing a modest advance in labour costs in the first quarter.

Other data showing a drop in consumer sentiment in April, the fourth consecutive monthly decline, and a softening in factory activity in the Midwest further supported the case for a single rate hike in 2016.

The data suggest, at least for now, that the economy will probably not rebound strongly in the second quarter after growth slowed to a crawl in the first three months of the year.

"The tone of these reports was quite weak, playing into the current narrative of weakening growth and the subdued inflationary momentum," said Millan Mulraine, deputy chief economist at TD Securities in New York. "We are expecting only one rate hike this year, with that move coming in September."

The Commerce Department reported that the personal consumption expenditures (PCE) price index, excluding the volatile food and energy components, edged up 0.1 percent last month after increasing 0.2 percent in February.

The so-called core PCE, which is the U.S. central bank's preferred inflation measure and is running below its 2 percent target, rose 1.6 percent in the 12 months through March, after advancing 1.7 percent in February.

Following its latest policy meeting this week, the Fed said it was continuing to "closely" monitor inflation. It left its benchmark overnight interest rate unchanged and suggested it was in no hurry to tighten monetary policy further.

The central bank hiked rates in December for the first time in nearly a decade and Fed policymakers earlier this year forecast two more rate hikes for 2016. But market-based measures of Fed policy expectations mostly lean to one hike this year.

The dollar fell to an eight-month low against a basket of currencies on the data. U.S. stocks tumbled and prices for U.S. government bonds weakened marginally.

MODEST WAGE INFLATION

In a separate report, the Labor Department said its employment Cost Index, the broadest measure of labour costs, increased 0.6 percent in the first quarter after gaining 0.5 percent in the fourth quarter.

Labour costs rose 1.9 percent in the 12 months through March, well below the 3 percent threshold that economists say is needed to bring inflation closer to the Fed's inflation target. The ECI increased 2.0 percent in the year to December.

The ECI is widely viewed by policymakers and economists as one of the better measures of labour market slack. It is also considered a better predictor of core inflation.

A strong dollar and lower energy prices are constraining inflation. Wage growth has been frustratingly slow and could remain moderate as the fairly robust labour market attracts people who had given up looking for work.

Though employment gains have been broad, they have tended to be concentrated in the services industries, especially restaurants and the retail sector, which typically pay less compared to manufacturing and construction jobs.

Lack of strong wage growth has contributed to moderate consumption growth. Consumer spending, which accounts for more than two-thirds of U.S. economic activity, ticked up 0.1 percent in March after a 0.2 percent gain in February.

The consumer spending figures were included in Thursday's gross domestic product report, which showed the economy growing at a 0.5 percent annual rate in the first quarter, a sharp slowdown from the fourth quarter's 1.4 percent pace.

With income rising 0.4 percent in March and savings jumping to a more than three-year high last month, consumer spending is expected to regain momentum.

But households are likely to remain hesitant to loosen their purse strings in the near term, with a third report on Friday showing the University of Michigan's consumer sentiment index dipped to 89.0 in April from a reading of 91.0 in March.

"There is scope for households to draw down their savings in the second quarter," said Steve Murphy, a U.S. economist at Capital Economics in Toronto. "When combined with healthy employment gains, healthy balance sheets, we think the conditions are ripe for a rebound in consumption growth in the second quarter."

In a fourth report, the Institute for Supply Management-Chicago said its Chicago business barometer declined 3.2 points to a reading of 50.4 in April as new orders fell and factory employment contracted. The report pointed to further downside risks to the troubled manufacturing sector.

(Reporting by Lucia Mutikani; Editing by Paul Simao)