By Lucia Mutikani
WASHINGTON (Reuters) - U.S. consumer prices unexpectedly fell in May and retail sales recorded their biggest drop in 16 months, suggesting a softening in domestic demand that could limit the Federal Reserve's ability to continue raising interest rates this year.
The Fed on Wednesday increased borrowing costs for the second time this year, while acknowledging the recent moderation in inflation pressures. Policymakers continued to expect the economy to expand at a "moderate" pace and labor market conditions to "strengthen somewhat" further.
"The latest inflation data have undoubtedly helped the case of officials arguing for waiting more than three months for the next move," said Jim O'Sullivan, chief U.S. economist at High Frequency Economics in Valhalla, New York.
The Labor Department said its Consumer Price Index dipped 0.1 percent last month, weighed down by declining prices for gasoline, apparel, airline fares, motor vehicles, communication and medical care services, among others.
The second drop in the CPI in three months followed a 0.2 percent rise in April. In the 12 months through May, the CPI rose 1.9 percent, the smallest increase since last November, after advancing 2.2 percent in April.
The year-on-year gain in the CPI in May was still larger than the 1.6 percent average annual increase over the past 10 years. Economists had forecast the CPI unchanged last month and advancing 2.0 percent from a year ago.
The so-called core CPI, which strips out food and energy costs, rose 0.1 percent in May after a similar gain in April as rents continued to increase moderately. The core CPI increased 1.7 percent year-on-year, the smallest rise since May 2015, after advancing 1.9 percent in April.
The Fed has a 2 percent inflation target and tracks an inflation measure which is currently at 1.5 percent. The Fed said on Wednesday it expected annual inflation rates to "remain somewhat" below 2 percent in the near term but stabilize around the central bank's target over the medium term. Chair Janet Yellen said they were monitoring inflation developments closely.
The Fed hiked its benchmark overnight interest rate by 25 basis points to range of 1.00 percent to 1.25 percent, and said it would start reducing its $4.2 trillion portfolio of Treasury bonds and mortgage-backed securities this year.
The dollar fell to a seven-month low against a basket of currencies on the data, before retracing some of the losses. Prices for U.S. Treasuries rallied, while stocks on Wall Street were little changed.
EYES ON INFLATION
Economists say the weakness in inflation, if sustained, could put further monetary tightening in jeopardy.
"Clearly officials will be mindful of incoming inflation trends in the coming months before greater confidence can be made with second half of the year policy normalization plans," said Sam Bullard, a senior economist at Wells Fargo (NYSE:WFC) Securities in Charlotte, North Carolina.
In a separate report, the Commerce Department said retail sales fell 0.3 percent last month amid declining purchases of motor vehicles and discretionary spending after a 0.4 percent increase in April. May's drop was the largest since January 2016 and confounded economists' expectations for a 0.1 percent gain.
Retail sales rose 3.8 percent in May on a year-on-year basis. While some of the drop in monthly retail sales reflected lower gasoline prices, which weighed on receipts at service stations, sales at electronics and appliance stores recorded their biggest decline since March 2010.
Excluding automobiles, gasoline, building materials and foodservices, retail sales were unchanged last month after an upwardly revised 0.6 percent rise in April. These so-called core retail sales correspond most closely with the consumer spending component of gross domestic product and were previously reported to have increased 0.2 percent in April.
Consumer spending accounts for more than two-thirds of the U.S. economy. Despite last month's weak core retail sales reading, low inflation could translate into higher consumer spending in the calculation of GDP.
The economy grew at a 1.2 percent annualized rate in the first quarter, held back by a near stall in consumer spending and a slower pace of inventory investment.
Output increased at a 2.1 percent pace in the October-December period. The Atlanta Fed is forecasting GDP rising at a 3.2 percent annualized rate in the second quarter.