WASHINGTON, June 28 (Reuters) - U.S. monthly inflation was unchanged in May as a modest increase in the cost of services was offset by the largest drop in goods prices in six months, drawing the Federal Reserve closer to start cutting interest rates later this year.
The report from the Commerce Department on Friday also showed consumer spending rose marginally last month. It raised optimism that the U.S. central bank could engineer a much-desired "soft landing" for the economy in which inflation falls without triggering a recession and a sharp rise in unemployment. Traders raised their bets for a Fed rate cut in September.
"It helps the argument that inflation is looking better-behaved, which may well open the door to interest rate cuts later in the year," said James Knightley, chief international economist at ING.
The flat reading in the personal consumption expenditures (PCE) price index last month followed an unrevised 0.3% gain in April, the Commerce Department's Bureau of Economic Analysis said. Goods prices dropped 0.4%, the most since November. There were big declines in prices of recreational goods and vehicles as well as furnishings and durable household equipment.
The price of gasoline and other energy goods dropped 3.4%. Clothing and footwear were also cheaper last month.
The cost of services increased 0.2%, lifted by higher prices for housing and utilities as well as healthcare. Financial services and insurance costs declined 0.3% after rising for five straight months. These costs, together with housing, have been among the major drivers of services inflation.
In the 12 months through May, the PCE price index increased 2.6% after advancing 2.7% in April. Last month's inflation readings were in line with economists' expectations.
Inflation is receding after spiking in the first quarter as 525 basis points worth of rate hikes from the Fed since 2022 cool domestic demand. Inflation, however, continues to run above the central bank's 2% target.
Financial markets saw a roughly 68% chance of a September rate cut compared to about 64% before the data, though policymakers recently adopted a more hawkish outlook. The Fed has maintained its benchmark overnight interest rate in the current 5.25%-5.50% range since last July.
U.S. stocks opened higher. The dollar was largely unchanged against a basket of currencies. U.S. Treasury prices were mostly higher.
SPENDING RISES MODERATELY
Excluding the volatile food and energy components, the PCE price index edged up 0.1% last month, the smallest gain since November. That followed an upwardly revised 0.3% rise in April.
The so-called core PCE price index was previously reported to have gained 0.2% in April. Core inflation increased 2.6% on a year-on-year basis in May, the smallest advance since March 2021, after rising 2.8% in April.
The Fed tracks the PCE price measures for monetary policy. Monthly inflation readings of 0.2% over time are necessary to bring inflation back to target.
PCE services inflation excluding energy and housing also ticked up 0.1% last month after advancing 0.3% in April. This so-called super inflation reading is being watched by policymakers to measure progress in lowering price pressures.
Consumer spending, which accounts for more than two-thirds of U.S. economic activity, increased 0.2% last month after rising 0.1% in April, the report also showed.
Inflation fatigue, higher borrowing costs as well as dwindling savings are holding back spending. Nonetheless, consumer spending remains supported by a resilient labor market, which continues to generate strong wage gains. Personal income increased 0.5% after climbing 0.3% in April. Wages shot up 0.7%.
Income at the disposal of households after accounting for inflation and taxes rose a solid 0.5%. Consumers saved more, lifting the saving rate to 3.9% from 3.7% in April.
Spending adjusted for inflation rebounded 0.3% after slipping 0.1% in April. The rise in the so-called real consumer spending bodes well for growth in consumption this quarter.
Consumer spending slowed sharply in the first quarter, helping to restrict the economy to a 1.4% annualized growth pace. The economy grew at a 3.4% pace in the fourth quarter.
Growth estimates for the second quarter are mostly below a 2% rate.
Reporting by Lucia Mutikani, Editing by Chizu Nomiyama and Paul Simao
