Weak U.S. Inflation Complicates Federal Reserve Plans

By Josh Mitchell Features Dow Jones Newswires

The U.S. economy is posing a puzzle: Higher consumer spending and falling unemployment point to healthy, even robust, growth. But a key measure of the economy's temperature -- inflation -- has weakened.

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The conflicting signals are complicating the Federal Reserve's plans to raise its benchmark interest rate once more before year-end.

Consumer prices grew 0.1% in July from a month earlier and just 1.4% over the past year, the Commerce Department said Thursday. Core prices, which strip out food and energy components, rose at the same pace. Both measures are below the 2% rate the Fed targets to ensure the economy runs neither too hot nor too cold. Inflation started the year at the Fed's goal but has since fallen.

The slowdown has defied Fed expectations of a rebound after temporary factors weighed on prices early in the year. For example, cellphone-plan prices fell sharply this spring due to a price war among providers, but the effects were expected to ease.

Instead, inflation has shown no sign of pickup this summer, with core prices growing at a 1.2% annual rate in the past three months. The slowdown is out of step with other evidence pointing to firming economic conditions in the U.S. The unemployment rate dropped to 4.3% in July, tying a 16-year low and below Fed projections of long-run trends. Economic output grew at a 3% rate in the second quarter, the strongest in more than two years, and some economists expect similar growth this summer.

"It appears that inflation is taking longer to respond to economic growth and labor market slack than in past cycles," Fotios Raptis, an economist at TD Economics, said in a note to clients. "But overall we continue to believe that price pressures will eventually pick up as the economic cycle continues to mature."

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The Fed has raised short-term interest rates twice this year and has indicated it wants to lift them once more before year-end. Such a move is designed to raise borrowing costs for households and businesses to keep the economy growing steadily without overheating. But with inflation weakening, higher borrowing costs invite the risk of reduced spending by consumers and businesses, which could further push inflation below the Fed's target and undermine the economic expansion.

Gregory Daco, chief U.S. economist at Oxford Economics, said he believes the latest data will "prevent the Fed from raising rates further in 2017." Instead, he expects the Fed to focus on shrinking its portfolio of bonds and other assets.

Thursday's report underscored the Fed's conundrum, with a continued pickup in spending that would normally be accompanied by higher inflation. Households boosted spending 0.3% in July from a month earlier. That is in line with reports showing Americans are shelling out more for a variety of goods and services as a booming stock market and steady job growth lift their spirits.

Americans' incomes -- reflecting wages, investment earnings and any government aid -- grew 0.4%, the strongest increase since February. That gives households more money to spend in coming months, which could lead to further economic gains. Some economists project the economic growth rate to hit 3% or more in the third quarter. The U.S. hasn't had back-to-back quarters of growth above 3% since 2014.

Write to Josh Mitchell at joshua.mitchell@wsj.com

(END) Dow Jones Newswires

August 31, 2017 12:49 ET (16:49 GMT)