US May PCE inflation rises 4.1%, keeping Fed hike in play

* Personal Consumption Expenditures price index increases 4.1% year-on-year in May

* Core PCE inflation advances 3.4% year-on-year; up 0.3% on a monthly basis

* Financial markets expect the Federal Reserve to hike interest rates in September

* Consumer spending powers ahead in May; business spending on equipment rebounds sharply

By Lucia Mutikani

WASHINGTON, June 25 (Reuters) - U.S. inflation increased further in May, breaking above 4.0% for the first time in three years as the Middle East conflict boosted energy prices, and keeping an interest rate increase from the Federal Reserve this year on the table. But with oil prices falling to pre-war levels on Thursday after the United States and Iran signed a preliminary peace deal, inflation likely peaked last month or is close to doing so. While easing oil prices could dampen goods inflation, that could be offset by more expensive services. Economists expected overall inflation to remain elevated for a while.

Financial markets are anticipating a rate hike from the U.S. central bank in September.

"PCE price inflation remains too high and will keep the Fed on hold and mulling a potential rate hike at upcoming meetings," said Scott Anderson, chief U.S. economist at BMO Capital Markets. "Services inflation was even higher than goods inflation last month and will not be easily tamed by falling energy prices. The fight between the hawks and the doves is sure to remain intense."

The personal consumption expenditures price index surged 4.1% in the 12 months through May, the largest increase and first reading above 4.0% since April 2023, the Commerce Department's Bureau of Economic Analysis said on Thursday. PCE inflation rose by an unrevised 3.8% in April.

Economists polled by Reuters had forecast PCE inflation advancing 4.1%. The PCE price index climbed 0.4% over the month after rising by the same margin in April. The U.S.-led war against Iran pushed up oil prices, driving gasoline prices higher, as Tehran took control of the Strait of Hormuz. On Thursday, Washington said shipments through the strait were approaching levels seen before the U.S. and Israel launched strikes on Iran on February 28, weighing on oil prices.

Consumers were before the conflict already struggling with higher prices stemming from Trump's sweeping import tariffs. The higher cost of living is a political liability for Trump and his Republican Party, seeking to retain control of Congress in the midterm elections in November, amid mounting frustration over his stewardship of the economy.

Trump won the 2024 presidential election in part because of his promise to lower inflation.

Excluding the volatile food and energy components, the PCE price index increased 3.4% year-on-year in May after rising 3.3% in April. The so-called core PCE inflation advanced 0.3% on a monthly basis after gaining 0.3% in April.

The U.S. central bank tracks the PCE inflation measures for its 2% target. The Fed last week kept its benchmark overnight interest rate in the 3.50%-3.75% range, but updated quarterly projections showed policymakers expected to raise borrowing costs this year amid growing concerns about inflation. Both headline and core PCE inflation were last below 2% in early 2021. Financial markets saw a roughly 80% chance that the Fed will raise rates at the September 15-16 meeting, according to CME Group's FedWatch tool. U.S. stocks were trading higher. The dollar eased against a basket of currencies. U.S. Treasury yields fell.

CONSUMERS BOOST SPENDING

Despite the high inflation last month, consumers boosted their spending, thanks to larger tax refunds this year as well as a stock market rally, which have cushioned some of the pain at the pump. Households are also tapping into savings and saving less.

Consumer spending, which accounts for more than two-thirds of economic activity, jumped 0.7% in May after rising 0.4% in April. Though some of the rise in spending reflects higher prices, consumption appears on track to speed up this quarter after nearly stalling in the January-March quarter.

But with inflation outpacing wage gains, the tax filing season behind and savings dwindling, economists expect households will dial back spending in the third quarter.

For now, consumers are combining with businesses to boost the economy. A separate report from the Commerce Department's Census Bureau showed businesses boosting spending on a range of goods in May. Non-defense capital goods orders excluding aircraft, a closely watched proxy for business spending, increased 1.6% last month after declining 0.7% in April.

Some of the rise in these so-called core capital goods, however, reflected higher prices, especially for memory chips. Businesses are ramping up investment in artificial intelligence, fueling demand for information processing equipment and other related products. That is helping to blunt the hit on manufacturing from the Middle East conflict.

Orders for computers and electronic products rebounded 0.3%, while those for electrical equipment, appliances and components rose 0.3%. There were hefty increases in orders for fabricated metal products, primary metals and machinery. Core capital goods shipments rose 0.3% in May after increasing 0.5% in April.

Business spending on equipment recorded double-digit growth in the first quarter. Orders for durable goods, items ranging from toasters to aircraft that are meant to last three years or more, fell 4.5% in May after surging 8.5% in April, the Census Bureau reported. They were dragged down by a 51.8% plunge in non-defense aircraft and parts orders, a very volatile category.

Boeing (BA) reported on its website that it had received only 27 aircraft orders in May compared to 136 in April.

Gross domestic product growth estimates for the second quarter are currently as high as a 3.0% annualized rate. The economy grew at a 2.1% pace in the first quarter.

(Reporting by Lucia Mutikani; Editing by Chizu Nomiyama and Andrea Ricci )