U.S. data points to firming economy, inflation

By Lucia Mutikani

WASHINGTON (Reuters) - Underlying U.S. inflation increased more than expected in February as rents and medical costs maintained their upward trend, which could keep the Federal Reserve on course to gradually raise interest rates this year.

Other data on Wednesday showed the housing market continuing to strengthen last month and manufacturing stabilizing. The Fed kept interest rates unchanged on Wednesday, but acknowledged that inflation "picked up in recent months."

New projections from the U.S. central bank showed policymakers expected two quarter-point rate increases by year-end, half the number seen in December. The combination of stirring inflation, a steady housing sector and tightening labour market have raised the probability of a rate hike in June.

"It looks like the Fed remains really cautious, they are not prepared to move before June at the earliest. Today's numbers, especially the inflation report, is a warning that the days of no price pressures are behind us," said Joel Naroff, chief economist at Naroff Economic Advisors in Holland, Pennsylvania.

The Labor Department said its Consumer Price Index, excluding the volatile food and energy components, rose 0.3 percent last month after a similar gain in January.

That lifted the so-called core CPI 2.3 percent in the 12 months through February, the largest increase since May 2012, after it advanced 2.2 percent in January. Economists polled by Reuters had forecast the core CPI rising 0.2 percent last month and increasing 2.2 percent from a year ago.

The Fed has a 2 percent inflation target and monitors a price measure that has also pushed higher in recent months. The Fed raised its benchmark overnight interest rate in December for the first time in nearly a decade.

Fed Chair Janet Yellen told reporters temporary factors were likely behind the recent run-up in prices, adding that policymakers expected a gradual rise in inflation.

"I want to warn that there may be some transitory factors that are influencing that. So I'm wary and haven't yet concluded that we have seen any significant uptick that will be lasting in, for example, in core inflation," said Yellen.

The dollar fell to a one-month low against a basket of currencies, while prices for U.S. Treasury debt gained. U.S. stocks rose, with homebuilding shares such as D.R. Horton Inc and Lennar Corp also getting a boost from the better housing data.

HOUSING, MANUFACTURING IMPROVING

In a separate report, the Commerce Department said housing starts increased 5.2 percent to a seasonally adjusted annual pace of 1.18 million units last month, the highest level in five months. [nLNNGEEC4K]

Groundbreaking activity had been held back by adverse weather. While the rebound in housing starts offered a lift to first-quarter gross domestic product growth estimates, that was offset by a drop in utilities output as temperatures warmed up in February.

First-quarter growth is forecast around a 2 percent annual rate, an acceleration from the 1.0 percent rate logged in the final three months of 2015.

In a third report, the Fed said industrial production declined 0.5 percent as mining and utilities tumbled. Industrial production rose 0.8 percent in January. But manufacturing output increased 0.2 percent last month after spiking 0.5 percent in January. [nFOMGEEC4B]

The rise in factory output added to manufacturing surveys in suggesting that the downturn in the sector, which accounts for 12 percent of the U.S. economy, had probably run its course. Factories have been hit by dollar strength and lower oil prices.

"The overall outlook for the U.S. industrial sector is beginning to look a little better," said Millan Mulraine, deputy chief U.S. economist at TD Securities in New York.

The housing sector is being supported by a firming labour market, which is encouraging young adults to leave their parents' homes. But builders cannot keep up with the demand for housing because of a shortage of lots and skilled labour, which is driving rents higher in major metropolitan areas.

The second month of broad increases in the core CPI was driven by a 0.3 percent increase in rents, which followed a similar gain in January.

Medical care costs rose 0.5 percent after advancing by the same margin in January. Prescription drug prices rose 0.9 percent, while the cost of hospital services increased 0.5 percent. Apparel prices rose by the most in seven years.

The second straight month of increase in apparel prices is rather surprising given that retailers have been giving big discounts to clear unwanted merchandise from their warehouses.

Consumers also paid more for new motor vehicles and used cars and trucks. But a 13 percent drop in gasoline prices, which offset both the increase in core CPI and a 0.2 percent gain in food prices, lead to the overall CPI falling 0.2 percent in February after being unchanged in January.

Last month's drop resulted in the CPI increasing 1.0 percent in the 12 months through February, slowing after a 1.4 percent rise in January.

(Reporting by Lucia Mutikani; Additional reporting by Jason Lange; Editing by Andrea Ricci and Chizu Nomiyama)