* Key U.S. inflation gauge slows to 3-1/2 year low
* Decline hardens views Fed to keep buying bonds
* Fed to maintain $85 bln bond buying pace this week
By Alister Bull
WASHINGTON, April 29 (Reuters) - A slowdown in a key measure of U.S. inflation in March will encourage Federal Reserve officials to keep aggressively buying bonds for most of 2013 and dim any enthusiasm for an early tapering of the program.
The U.S. central bank wants to drive down high unemployment while keeping inflation near its 2 percent target. Data released on Monday showed prices were heading in the wrong direction.
The Fed’s favored gauge of consumer prices - the personal consumption expenditures price index - fell to 1.0 percent year-on-year in March from 1.3 percent in February. It was the smallest gain in 3-1/2 years.
“This is another force pushing toward the Fed continuing on, with no tapering (of bond purchases) this year,” said Dean Maki, chief U.S. economist at Barclays Capital in New York.
On the other hand, it will take evidence of weaker growth and a softer labor market spilling into more widespread expectations for lower prices to prompt the Fed to seriously consider increasing the scale of bond purchases, he said.
The Fed is currently buying $85 billion of longer-dated U.S. Treasuries and mortgage-backed bonds every month. It is expected to vote to keep doing so at the conclusion of a two-day policy-setting meeting on Wednesday. A statement announcing the decision is scheduled for release at 2 p.m. (1800 GMT).
Commodity prices have slipped in recent weeks, with gold falling sharply and Brent oil prices also down some 13 percent from a February peak around $119 a barrel.
The Fed tries to look past short-term swings in energy and food prices. Instead, it focuses on trends in so-called core inflation, which excludes these often-volatile prices.
But the core PCE price index has also been dropping. In March, it dipped to 1.1 percent - the lowest in 2 years - from 1.3 percent in February.
“Core PCE inflation briefly hit the Fed’s 2.0 percent target in March 2012 for the first time since 2008, but it has fallen by almost a point now in the past year after a substantial slowing since mid-2012,” said Ted Wieseman at Morgan Stanley.
“Along with the sluggish outlook for second quarter growth, the increasing miss on the inflation side of the Fed’s dual mandate we believe has removed the risk of an early start to QE tapering.”
At the Fed’s last meeting in late March, some officials voiced confidence that improving U.S. economic growth might warrant a tapering in the pace of bond buying in coming months, according to minutes of the meeting.
But a weak March employment report released earlier this month, plus other softer signals from the economy, appeared to make that less likely. The dip in prices cements that view.
“Both core and headline inflation are now about 100 basis points (1 percentage point) below the Fed’s 2 percent long-term goal,” Michael Darda, chief economist at MKM Partners LLC, wrote in a note to clients.
“With unemployment still about 200 basis points above what the Fed believes is its long-term sustainable level, previous talk of Fed tapering should die down even if the macro data strengthens.”
The unemployment rate was 7.6 percent in March and Fed officials think they could get it down to the 5.2 percent to 6 percent range before wage pressures increase enough to threaten a rise in inflation.
The Fed specifically targets 2 percent inflation as measured by the PCE price index and not the more popular Consumer Price Index. The CPI stood at 1.5 percent year-over-year in March, while core CPI was up 1.9 percent from a year ago.
The difference might matter to policymakers because Treasury Inflation Protected Securities, or TIPS, which the Fed uses to weigh expectations for future inflation, are calculated using the CPI.
The Fed will seek confirmation that lower inflation as measured by the PCE price index is getting baked into expectations for lower prices generally, before giving credence to the risk of a damaging deflationary trend that would warrant raising the pace of bond buying.
This is not yet happening. The break-even spread for the 10-year TIPS, which measures the difference in yield between the TIPS and a normal Treasury note, was 2.35 percent in Monday afternoon trading, little changed from late last week.