By Lucia Mutikani
WASHINGTON (Reuters) - U.S. retail sales rose more than expected in January and consumer prices recorded their biggest gain in nearly four years, boosting prospects of an interest rate increase from the Federal Reserve next month.
The economy's strengthening outlook was also bolstered by other data on Wednesday showing manufacturing and mining production rising last month as the drag from lower oil prices fades. The reports came as Federal Reserve Chair Janet Yellen appeared to put a March interest rate hike on the table.
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"All things consumer show the economy is starting the year off with a bang," said Chris Rupkey, chief economist at MUFG Union Bank in New York. "Interest rates are too low and with an economy this strong rates need to be put on a preset course higher."
The Commerce Department said retail sales increased 0.4 percent last month, buoyed by purchases of electronics and appliances. Households also spent more on dining out, sporting goods and hobbies.
December's sales were revised up to show a 1.0 percent rise instead of the previously reported 0.6 percent advance. Sales rose despite motor vehicle purchases posting their biggest drop in 10 months.
Compared to January last year retail sales were up 5.6 percent. Excluding automobiles, gasoline, building materials and food services, retail sales increased 0.4 percent after a similar gain in December.
These so-called core retail sales correspond most closely with the consumer spending component of gross domestic product. Economists polled by Reuters had forecast retail sales ticking up 0.1 percent and core sales gaining 0.3 percent last month.
In the wake of the data financial markets were pricing in a 27 percent chance of an interest rate hike at the Fed's March 14-15 policy meeting, up from 18 percent late on Tuesday, according to CME Group's FedWatch program.
The dollar briefly rose to a one-month high versus a basket of currencies on the data, before surrendering gains to trade marginally lower. Prices for U.S. government bonds fell, while Wall Street extended its record-setting run for a fifth day.
In a separate report, the Labor Department said its Consumer Price Index jumped 0.6 percent last month as households paid more for gasoline, new motor vehicles, airline fares and clothing. It was the largest increase since February 2013 and followed a 0.3 percent gain in December.
In the 12 months through January, the CPI increased 2.5 percent, the biggest year-on-year gain since March 2012. The CPI rose 2.1 percent in the year to December. Inflation is trending higher as prices for energy goods and other commodities rebound in response to a pick-up in global demand.
The so-called core CPI, which strips out food and energy costs, rose 0.3 percent last month after increasing 0.2 percent in December. That lifted the year-on-year core CPI increase to 2.3 percent in January from December's 2.2 percent rise.
The Fed has a 2 percent inflation target and tracks an inflation measure which is currently at 1.7 percent.
Strengthening domestic demand together with firming inflation and a tightening labor market could allow the Fed to raise interest rates at least twice this year.
Testifying before lawmakers on Wednesday, Yellen reiterated that it would be "unwise" for the U.S. central bank to wait too long to raise interest rates.
The U.S. central bank has forecast three rate increases this year. The Fed hiked its overnight interest rate last December by 25 basis points to a range of 0.50 percent to 0.75 percent.
Despite January's strong inflation and retail sales reports, many economists only expect two rate hikes in 2017.
"Recent rhetoric from Fed officials has turned marginally more hawkish lately. We still think March is too early for them to hike, particularly given their propensity to prepare markets for a move," said Michael Feroli, an economist at JPMorgan in New York. "We continue to look for two hikes this year."
A third report from the Fed showed manufacturing production increased 0.2 percent in January after a similar rise in December. Output at mines shot up 2.8 percent, with oil and gas well drilling increasing further.
While the reports on Wednesday suggested the economy regained momentum early in the first quarter, rising inflation means households have less spending power. Average hourly earnings adjusted for inflation fell 0.5 percent in January and were unchanged from a year ago.
"This is not the best thing in the world for lower income households living paycheck-to-paycheck," said Chris Christopher, an economist at IHS Global Insight in Lexington, Massachusetts.
Still, Christopher said an improving labor market would support relatively robust consumer spending.
"Household finances are in good shape, thanks to gains in both home prices and stock prices, along with debt deleveraging," he added.
(Reporting by Lucia Mutikani; Additional reporting by David Lawder; Editing by Andrea Ricci)