By Lucia Mutikani
WASHINGTON (Reuters) - U.S. consumer prices rose slightly in May, but over the past 12 months prices registered the biggest drop in nearly 60 years, allaying fears that inflation threatens an economic recovery.
The Labor Department said on Wednesday higher gasoline prices contributed to the smaller-than-expected 0.1 percent rise in its Consumer Price Index from April when the CPI was unchanged from the previous month. Financial markets had expected a 0.3 percent increase in May.
Compared to the same period last year, the CPI fell 1.3 percent, the largest decline since April 1950. The pace of the price decline also accelerated -- the CPI dropped 0.7 percent year-on-year in April.
The data soothed worries that massive spending by the U.S. government and the Federal Reserve to pull the economy out of an 18-month-long recession -- the longest since the Great Depression -- may end up fueling inflation.
"There is no sign that there has been widespread inflation because of the Fed's quantitative easing regime. In fact, long-term inflation expectations haven't budged and the Fed is still ahead of curve on inflation," said John Canally, an economist and investment strategist at LPL Financial in Boston.
U.S. stocks rose modestly <.DJI>, with the benign inflation report overshadowed by a gloomy forecast from package delivery company FedEx Corp
U.S. government bond prices rose on the data as traders scaled back bets the Fed could be forced to bump up interest rates by year end. Fed officials, who have held overnight rates near zero since December, will meet on Tuesday and Wednesday to debate their next move.
A separate report from the Commerce Department showed the deficit in the U.S. current account, the broadest measure of the United States' international trade, shrank in the first quarter to $101.5 billion, the smallest gap since the fourth quarter of 2001..
CORE PRICES SLOWER
The Labor Department said core prices, excluding food and energy, also rose only 0.1 percent in May, slower than April's 0.3 percent monthly gain, as prices for tobacco and smoking products fell after surging the last two months on the back of a federal excise tax increase.
It was the smallest monthly rise in the core CPI since December. The gain reflected a fifth straight monthly increase in new vehicle prices. Shelter and medical costs also rose.
Over the past 12 months, core prices have increased 1.8 percent, a bit slower than the 1.9 percent rise seen in the period ended in April.
Some analysts said core inflation could still be considered uncomfortably high, given that the economy has been in recession for a year-and-a-half.
"We could have an inflation problem going forward, but it's going to have to wait until we get a resuscitation of the banking system," said Howard Simons, a strategist at Bianco Research in Chicago. "Once that happens, we could get an inflation shock."
Gasoline prices rose 3.1 percent in May versus a 2.8 percent drop in April, but the increase was mitigated by a 0.2 percent fall in food prices.
Government data on Tuesday showed wholesale inflation was muted in May, despite higher gasoline prices. Compared to the same period last year, prices paid at the farm and factory gate experienced their steepest fall since 1949.
Investors have been pricing in rising inflation risks in the bond market. Benchmark Treasury debt yields spiked to an eight-month high last week. The yield difference between Treasury Inflation-Protected Securities, or TIPS, and other Treasury bonds has grown since the beginning of the year, another sign of mounting concern on prices.
But some analysts reckon the bond market is getting ahead of itself and argue the economy is more at risk of deflation than inflation.
"Bond market participants should be more concerned with the risks of deflation than the acceleration in inflation evident in the TIPS implied premium," said Steven Ricchiuto, chief economist at Mizuho Securities in New York.
The spike in U.S. Treasury debt yields has sent mortgage rates soaring. Applications for mortgages fell last week for a fourth consecutive week, with overall demand diving to a near seven-month low.
Analysts reckon the Fed could play down the market's inflation expectations at its policy meeting next week and signal some scaling back on its purchases of U.S. Treasuries.
"They may signal that they are going to pull back from more aggressive quantitative easing. The deficit we need to finance is so out of control," said Bianco Research's Simons.
(Additional reporting by Alister Bull in Washington and Richard Leong in New York; Editing by Kenneth Barry)
