By Lucia Mutikani
WASHINGTON (Reuters) - U.S. consumer spending cooled in January as demand for automobiles and utilities fell, but inflation recorded its biggest monthly increase in four years, raising the probability of an interest rate hike from the Federal Reserve this month.
The tepid gain in consumer spending added to weak housing starts, equipment spending and construction data in suggesting economic growth remained moderate early in the first quarter after slowing in the final three months of 2016.
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Despite the softness on the demand-side of the economy, the manufacturing sector recovery is gaining steam. Factory activity hit a 2-1/2-year high in February, other data showed on Wednesday.
"A weak start to the year for consumers suggests a downside risk to first-quarter growth prospects, though it likely won't quell recent chatter about a March Fed rate hike," said Sal Guatieri, a senior economist at BMO Capital Markets in Toronto.
The Commerce Department said consumer spending, which accounts for more than two-thirds of U.S. economic activity, increased 0.2 percent after rising 0.5 percent in December.
Consumer spending is likely to remain supported amid promises by the Trump administration of sweeping tax cuts and increased infrastructure spending.
In a speech to Congress on Tuesday night, President Donald Trump said his economic team was working on a "historic" tax reform that would slash corporate taxes. Trump promised "massive" tax cuts for the middle class, but offered no further details. Consumer confidence has surged following Trump's Nov. 8 election victory, hitting a 15-1/2-year high in February.
In January the personal consumption expenditures (PCE) price index increased 0.4 percent - the largest gain since February 2013 - after rising 0.2 percent in December.
In the 12 months through January, the PCE price index jumped 1.9 percent. That was the biggest year-on-year gain since October 2012 and followed a 1.6 percent increase in December.
Excluding food and energy, the so-called core PCE price index rose 0.3 percent in January. That was the biggest increase since January 2012 and followed a 0.1 percent gain in December.
The core PCE price index increased 1.7 percent year-on-year after a similar gain in December. The core PCE is the Fed's preferred inflation measure.
While still below the U.S. central bank's 2 percent target, inflation is now in the upper end of the range that Fed officials in December estimated would be reached this year.
"COMPELLING" CASE FOR RATE HIKE
The strong inflation readings come a day after New York Fed President William Dudley said the case for further monetary policy tightening had become a "lot more compelling."
Prices for U.S. Treasuries fell, with the yield on the interest-rate sensitive 2-year note <US2YT=RR> hitting its highest level since August 2009. Fed funds futures were pricing in about a 65 percent chance of a rate hike at the Fed's March 14-15 policy meeting.
The dollar touched a seven-week high against a basket of currencies. Stocks on Wall Street rose, with the Dow Jones Industrial Average <.DJI> breaching the 21,000 mark for the first time ever as investors focused on Trump's comments.
The U.S. central bank has forecast three rate increases this year. The Fed hiked its overnight interest rate last December.
In a separate report on Wednesday, the Institute for Supply Management said its index of national factory activity increased to a reading of 57.7 last month, the highest since August 2014, from 56.0 in January.
A reading above 50 indicates an expansion in manufacturing, which accounts for about 12 percent of the U.S. economy. Some of the increase likely reflects a surge in business confidence following Trump's election.
But that has not been matched by a strong increase in business spending on capital goods. Business spending on equipment rose moderately in the fourth quarter and appeared to weaken in January, data showed this week.
"For now, businesses and households appear confident, but have yet to act on that confidence," said Michael Feroli, an economist at JPMorgan in New York. "When it comes to calculating GDP it is the hard data that matters, and so far the hard activity data for the first quarter has been disappointing."
Rising inflation is eroding consumer spending. When adjusted for inflation, consumer spending fell 0.3 percent in January, the first drop since August and the biggest in three years. It increased 0.3 percent in December and January's drop implies consumer spending will probably not provide a big boost to GDP in the first quarter
Consumer spending increased at a 3.0 percent annualized rate in the fourth quarter, helping to blunt some of the impact on the economy from a wider trade deficit.
The economy grew at a 1.9 percent rate in the fourth quarter and the Atlanta Fed is forecasting GDP rising at a 1.8 percent pace this quarter. Another report from the Commerce Department on Wednesday showed construction spending declined 1.0 percent in January.
Personal income rose 0.4 percent in January after gaining 0.3 percent in December. Income at the disposal of households after accounting for inflation, fell 0.2 percent, the first decline since October 2013.
(Reporting by Lucia Mutikani; Editing by Andrea Ricci)