Data on Tuesday showing both healthy economic activity and rising inflation have re-ignited the debate over whether the Federal Reserve will raise interest rates when it meets next week.

Last week investors sharply cut back their expectation of further monetary tightening following unexpectedly weak growth data. But yesterday’s series of data triggered fresh speculation that the Fed would indeed act next week.

The Institute for Supply Management’s July manufacturing activity index unexpectedly rose, reaching 54.7 from 53.8 and outstripping expectations of a slight dip. Earlier, the Commerce Department’s personal income and expenditure report showed a rise in
core inflation of 0.2 per cent in June for an annual rate of 2.4 per cent – above the Fed’s 2 per cent “comfort zone” assumed by the market.

“While the rise in the core price index is no surprise, it’s still not comforting as the trend has been toward higher prices,” said analysts at Action Economics.

The measure, known as the PCE deflator, is considered the Fed’s preferred inflation gauge. Annualising the past three months of data pushes the report’s core inflation rate to 2.9 per cent.

“With the Fed’s favoured measure of inflation rising at the fastest pace since September 2002 and pipeline price pressures clearly intensifying, a rate hike cannot be ruled out next week,” said James Knightley at ING Financial Markets.

“[The] ISM manufacturing index has made next week’s Fed rate decision an even closer call.”

Interest rate futures markets were pricing in about a 40 per cent chance of a rate rise, up from about 30 per cent at the beginning of the week.

Before last week’s growth data the likelihood had been about 50-50 and before that, had even been as high as 90 per cent.

A rate rise next week would be the 18th consecutive quarter-point rise and take the Fed funds target to 5.5 per cent.

“If they don’t tighten, they had better be right that core inflation will ease, or they have a major credibility problem on their hands,” said Alan Ruskin, strategist at RBS Greenwich Capital.

The Commerce Department report also showed healthy consumer patterns, with personal incomes up 0.6 per cent and spending up 0.4 per cent. Other data covering construction spending and pending home sales, both for June, also came in above expectations and added to the image of a relatively strong economy.

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