By Lucia Mutikani
WASHINGTON (Reuters) - U.S. producer prices unexpectedly fell in September, leading to the smallest annual increase in nearly three years, likely giving the Federal Reserve further room to cut interest rates for the third time this year in October.
The weak producer inflation readings reported by the Labor Department on Tuesday came against the backdrop of a slowing economy amid trade tensions and cooling growth overseas. The Trump administration's 15-month trade war with China has eroded business investment and pushed manufacturing into recession.
Economists say the broad weakness in producer inflation was a reflection of the downturn in the factory sector.
"This is helping to build the case for the Fed to take out some more insurance to guard against a broader downturn in the economy ," said Chris Rupkey, chief economist at MUFG in New York. "The trade war is hurting margins and pricing power for manufacturers, making it hard to see how America is winning this trade war with the world."
The producer price index for final demand dropped 0.3% last month, weighed down by decreases in the costs of goods and services, the government said. That was the largest decline since January and followed a 0.1% gain in August.
In the 12 months through September the PPI increased 1.4%, the smallest gain since November 2016, after rising 1.8% in August. Economists polled by Reuters had forecast the PPI nudging up 0.1% in September and advancing 1.8% on a year-on-year basis.
Excluding the volatile food, energy and trade services components, producer prices were unchanged last month after jumping 0.4% in August. The so-called core PPI increased 1.7% in the 12 months through September after climbing 1.9% in August.
The Fed, which has a 2% annual inflation target, tracks the core personal consumption expenditures (PCE) price index for monetary policy. The core PCE price index rose 1.8% on a year-on-year basis in August and has undershot its target this year.
Some economists expect the U.S. central bank could cut rates at its Oct. 29-30 policy meeting amid signs that the U.S.-China trade war was impacting the broader economy.
While the unemployment rate dropped to near a 50-year low of 3.5% in September, hiring slowed significantly, with the three-month average gain in private payrolls falling to 119,000 jobs, the smallest since July 2012, from 135,000 in August.
In addition, private services industry growth slowed to a three-year low in September.
A report on Tuesday from the National Federation of Independent Business showed confidence among small businesses dropped in September. The NFIB said the trade war was "adversely impacting many small firms," noting that "owners are more reluctant to make major spending commitments."
The Fed cut rates in September after reducing borrowing costs in July for the first time since 2008, to keep the longest economic expansion on record, now in its 11th year, on track.
U.S. financial markets were little moved by the inflation data as investors digested news that the White House was moving ahead with discussions around possible restrictions on capital flows into China, with a focus on investments made by U.S. government pension funds.
The dollar inched up against a basket of currencies. U.S. Treasury prices rose. Stocks on Wall Street were trading lower.
BROAD WEAKNESS
Though the relationship between producer and consumer inflation has weakened following the revamping of the PPI basket several years ago, economists expect a weak consumer price index reading in September. According to a Reuters survey of economists, the CPI likely rose 0.1% in September after a similar gain in August.
"The drop in the PPI in September does lend some downside risk to the CPI forecast," said Ryan Sweet, a senior economist at Moody's Analytics in West Chester, Pennsylvania.
The CPI data will be published on Thursday.
In September, wholesale energy prices fell 2.5%, matching August's decline. They were pulled down by a 7.2% decline in gasoline prices, which followed a 6.6% percent drop in August.
Gasoline accounted for three quarters of the 0.4% drop in goods prices last month. Goods prices decreased 0.5% in August. In the 12 months through September, goods prices declined 0.5%, the most since August 2016.
Wholesale food prices rebounded 0.3% in September, lifted by a 26.8% surge in the cost of chicken eggs. Food prices dropped 0.6% in August. Core goods prices fell 0.1% last month. They were unchanged in August.
The cost of services fell 0.2%, the most since February 2017, after increasing 0.3% in August. Services were dragged down by a 1.0% tumble in trade services, which measure changes in margins received by wholesalers and retailers.
Nearly half of the drop in services was attributed to a 2.7% decrease in machinery and vehicle wholesaling.
The cost of healthcare services rose 0.3% after climbing 0.2% in August. The cost of hospital outpatient care surged 1.1%, the biggest rise since 2014, after slipping 0.1% in August.
There were gains in the costs of doctor visits and hospital inpatient care. Portfolio management fees were unchanged last month after increasing 0.5% in August. Those fees and healthcare costs feed into the core PCE price index.
Economists at JPMorgan (NYSE:JPM) said while they expected medical care costs in the core PCE price index to jump 0.4% in September after being soft in August, they did not anticipate a similarly strong core inflation reading.
"The broader core PCE price index may not be especially strong given softness in some other PPI components that are used as source data for PCE prices," said JPMorgan economist Daniel Silver.
The September PCE price index data will be published at the end of the month.