By Lucia Mutikani
WASHINGTON (Reuters) - U.S. consumer spending rose less than expected in January as the largest monthly increase in inflation in four years eroded households' purchasing power, pointing to moderate economic growth in the first quarter.
The surge in inflation raises the possibility of an interest rate increase from the Federal Reserve this month. While still below the U.S. central bank's 2 percent target, inflation is now in the upper end of the range that Fed officials in December felt would be reached this year.
Despite the signs of moderate economic growth early in the first quarter, the recovery in the manufacturing sector is gaining traction, with factory activity surging to a 2-1/2-year high in February, other data showed on Wednesday.
"It would appear to suggest the economy is getting off to yet another abysmal start to a year in the first quarter," said Paul Ashworth, chief U.S. economist at Capital Economics in Toronto. "Core inflation is gradually closing in on target, which partly explains why Fed officials appear to be making the case for a March interest rate hike."
The Commerce Department said consumer spending, which accounts for more than two-thirds of U.S. economic activity, increased 0.2 percent after rising 0.5 percent in December. Economists polled by Reuters had forecast consumer spending gaining 0.3 percent in January.
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Consumer spending is likely to remain supported amid promises by the Trump administration of sweeping tax cuts and increased infrastructure spending.
In a speech to Congress on Tuesday night, President Donald Trump said his economic team was working on a "historic tax reform that will reduce the tax rate on our companies" and promised a "massive" tax relief for the middle class. Trump offered no further details.
Consumer confidence has surged following Trump's election victory, hitting a 15-1/2-year high in February.
In January the personal consumption expenditures (PCE) price index increased 0.4 percent - the largest gain since February 2013 - after rising 0.2 percent in December.
In the 12 months through January, the PCE price index jumped 1.9 percent. That was the biggest year-on-year gain since October 2012 and followed a 1.6 percent increase in December.
Excluding food and energy, the so-called core PCE price index rose 0.3 percent in January. That was the biggest increase since January 2012 and followed a 0.1 percent gain in December.
The core PCE price index increased 1.7 percent year-on-year after a similar gain in December. The core PCE is the Fed's preferred inflation measure.
Prices for U.S. Treasuries fell, with the yield on the interest-rate sensitive 2-year note rising to its highest level since August 2009. Fed funds futures were pricing in a 65 percent chance of an interest rate hike at the Fed's March 14-15 policy meeting.
The U.S. central bank has forecast three rate increases this year. The Fed hiked its overnight interest rate last December by 25 basis points to a range of 0.50 percent to 0.75 percent.
The dollar rose against a basket of currencies, while U.S. stocks were trading higher.
In a separate report on Wednesday, the Institute for Supply Management (ISM) said its index of national factory activity increased to a reading of 57.7 last month, the highest since August 2014, from 56.0 in January.
A reading above 50 indicates an expansion in manufacturing, which accounts for about 12 percent of the U.S. economy. Some of the increase likely reflects a surge in business confidence following Trump's election victory last November.
The spike in confidence, however, has not been matched by a strong increase in business spending on capital goods. Business spending on equipment increased at an only a 1.9 percent annual rate in the fourth quarter and appeared to weaken in January, government data showed this week.
REAL SPENDING FALLS
Rising price pressures suggest that consumer spending will probably not provide a big boost to gross domestic product in the first quarter. When adjusted for inflation, consumer spending fell 0.3 percent in January, the first drop since August and the biggest in three years. Real consumer spending increased 0.3 percent in December.
Consumer spending increased at a 3.0 percent annualized rate in the fourth quarter, helping to blunt some of the impact on the economy from a wider trade deficit. The economy grew at a 1.9 percent rate in the fourth quarter and likely maintained that pace early in the first quarter.
Another report from the Commerce Department on Wednesday showed construction spending declined 1.0 percent in January after gaining 0.1 percent in December.
Consumer spending in January was held back by a 0.3 percent drop in purchases of long-lasting manufactured goods such as automobiles. Spending on services was unchanged.
Personal income rose 0.4 percent in January after gaining 0.3 percent in December. Wages and salaries rose 0.4 percent.
Income at the disposal of households after accounting for inflation and taxes, fell 0.2 percent, the first decline since October 2013. Savings increased to $795.7 billion in January from $779.5 billion in December.
(Reporting by Lucia Mutikani; Editing by Andrea Ricci)