Consumer prices up sharply as jobless claims rise

WASHINGTON (Reuters) - U.S. consumer prices rose briskly last month on energy costs, but outside volatile energy, inflation was largely contained, leaving room for the Federal Reserve to cut interest rates to bolster a slowing economy.

A second government report on Thursday showed an unexpectedly steep rise in initial claims for jobless benefits last week, a suggestion the labor market is softening as the economy lumbers under the weight of a housing downturn, tighter credit and higher energy prices.

The Consumer Price Index, the most broadly used gauge of inflation, rose 0.3 percent in October for a second straight month as energy prices posted their biggest rise since May.

But core prices, which strip out volatile energy and food costs, rose a more modest 0.2 percent in October. Both the overall and core reading were in line with financial market expectations.

Core inflation was held in check by falling prices for new and used vehicles and household furnishings. Shelter costs, which make up almost a third of the price index, advanced more slowly than in recent months.

The moderate core inflation reading may give the Federal Reserve some breathing room as it decides whether further interest rate cuts are necessary to counter financial market turbulence and a worrisome housing downturn.

"The CPI data was 'tame' enough that it clears the way for the Federal Reserve to lower interest rates again," said Sean Broderick, an analyst at investment research firm Weiss Research, Inc. in Jupiter, Florida.

Prices for U.S. government bonds rose as traders saw the data providing the inflation-wary Fed some latitude to take interest rates lower. Stocks pared losses and the dollar rose against the euro but slipped against the yen.

After the data, markets were betting the likelihood of a Fed rate cut at the group's December meeting was 90 percent, up from 72 percent late on Wednesday.

HEADLINE INFLATION MATTERS

Although policy-makers pay close attention to core inflation measures, the Fed signaled this week it will be paying more heed to overall inflation as it projects economic trends farther into the future.

"Ultimately, households and businesses care about the overall, or 'headline,' rate of inflation; therefore the (Fed) should refer to an overall inflation rate when evaluating whether the committee has met its mandated objectives over the long run," Fed Chairman Ben Bernanke said in a speech on Wednesday.

The data on Thursday showed the effect of higher food and energy prices over recent months.

Consumer prices were 3.5 percent higher than a year ago, the biggest 12-month increase since August 2006, when they rose 3.8 percent, a Labor Department official said. Core prices were up 2.2 percent on a year-on-year basis.

So far this year, prices have climbed by a seasonally adjusted annual rate of 3.6 percent, driven by higher food and energy costs. That compares with a 2.5 percent gain in all of 2006.

Energy costs have surged at a 12.3 percent annual rate this year, more than four times higher than the 2.9 percent gain in all of last year. Food prices increased at a 5.5 percent annual rate in 2007, compared with a 2.1 percent rise in 2006.

JOBLESS CLAIMS RISE

A separate Labor Department report showed new applications for U.S. jobless aid rose more than expected to a seasonally adjusted 339,000 last week, and the more-reliable four-week moving average held steady at a 6-month high.

Initial claims for state unemployment insurance benefits rose by 20,000 from an upwardly adjusted 319,000 the prior week.

Reports from the New York and Philadelphia Federal Reserve banks also suggested the economy was softening.

A report from the New York Fed showed manufacturing sector growth in New York state slowed in November, with new orders and inventory activity weakening and a big spike in material costs.

Still, the 27.37 reading on the New York Fed's "Empire State" general business conditions index, one of the earliest monthly snapshots of U.S. factory conditions, was higher than Wall Street economists had expected.

Another report, the Philadelphia Fed survey of business conditions, showed factory activity in the mid-Atlantic region jumped in November but employment fell and companies' forecasts for the future darkened.

(Additional reporting from Richard Leong and Steven C. Johnson in New York)

(Editing by Andrea Ricci)