By Lucia Mutikani
WASHINGTON (Reuters) - U.S. consumer spending increased solidly in July, suggesting strong economic growth early in the third quarter, while a measure of underlying inflation hit the Federal Reserve's 2 percent target for the third time this year.
Other data on Thursday showed an increase in new applications for unemployment benefits last week, but the underlying trend continued to point to a robust labor market.
There are, however, concerns the Trump administration's protectionist trade policy, which has led to an escalating trade war with China and tit-for-tat import tariffs with other trading partners, including the European Union, Canada and Mexico, could hurt the economy.
"The trade war thunder on the horizon hasn't moved closer to shore," said Chris Rupkey, chief economist at MUFG in New York. "Consumers are doing their part to keep the economy's engines running strong in the second half of the year."
The Commerce Department said consumer spending, which accounts for more than two-thirds of U.S. economic activity, rose 0.4 percent last month after advancing by the same margin in June. Households spent more at restaurants and on accommodation last month.
There was also an increase in spending on prescription medication. Last month's rise in consumer spending was in line with economists' expectations.
Prices continued their gradual upward trend in July. The personal consumption expenditures (PCE) price index excluding the volatile food and energy components rose 0.2 percent after edging up 0.1 percent in June.
That lifted the year-on-year increase in the so-called core PCE price index to 2.0 percent from 1.9 percent in June. The core PCE index is the Fed's preferred inflation measure. It hit the U.S. central bank's 2 percent inflation target in March for the first time since April 2012.
Minutes of the Fed's July 31-Aug. 1 meeting published last week showed some policymakers worried that "a prolonged period in which the economy operated beyond potential could give rise to inflationary pressures."
Given strong domestic demand and a tightening labor market, inflation could rise further, likely keeping the Fed on track to increase interest rates for a third time this year in September. Import duties, which have boosted prices for raw materials such as steel, lumber and aluminum, are seen fanning inflation.
"Inflation pressures should intensify in coming quarters," said Ryan Sweet, a senior economist at Moody's Analytics in West Chester, Pennsylvania. "Therefore, the Fed is going to continue to raise rates once per quarter through the remainder of this year and into next."
The dollar was trading marginally higher against a basket of currencies, while U.S. Treasury yields dropped. Stocks on Wall Street were mostly lower amid lingering concerns over trade tensions between the United States and China.
TIGHTENING LABOR MARKET
While rising inflation is eating into consumer spending, the pace of growth in consumption is enough to continue driving the economy. Inflation-adjusted consumer spending gained 0.2 percent in July, the smallest rise in five months, after increasing 0.3 percent in June.
Strong consumer spending helped fire up the economy in the second quarter, with gross domestic product rising at a 4.2 percent annualized rate, the fastest in nearly four years and almost double the 2.2 percent pace notched in the January-March period.
Consumer spending should blunt some of the impact on the economy from an anticipated widening in the trade deficit and weakness in the housing market in the third quarter. Recent data showed a sharp rise in the goods trade deficit in July as well as further declines in home sales and a moderate rise in homebuilding last month.
Spending is being supported by the labor market, which is viewed as being near or at full employment, as well as the Trump administration's $1.5 trillion tax cut package.
In a separate report on Thursday, the Labor Department said initial claims for state unemployment benefits increased 3,000 to a seasonally adjusted 213,000 for the week ended Aug. 25.
The four-week moving average of initial claims, considered a better measure of labor market trends as it irons out week-to-week volatility, fell 1,500 last week to 212,250, the lowest level since December 1969.
In July, spending on goods rose 0.2 percent after slipping 0.1 percent in June. Outlays on services increased 0.4 percent after surging 0.6 percent in the prior month. Personal income rose 0.3 percent in July after advancing 0.4 percent in the prior month.
Wages rose 0.4 percent. Higher inflation, however, is cutting into those gains. Income at the disposal of households after adjusting for inflation climbed 0.2 percent last month after increasing 0.3 percent in June. Savings were little changed at $1.05 trillion.
"Households have a healthy cushion of savings into which they can dip to sustain spending," said Michelle Girard,chief U.S. economist at NatWest Markets in Stamford, Connecticut.
(Reporting by Lucia Mutikani; Editing by Paul Simao)
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