(Adds details, analyst comments, updates markets)
* Retail sales fall 0.3 percent in May
* Core retail sales unchanged; April revised up
* Consumer price index dips 0.1 percent in May
* Core CPI gains 0.1 percent; up 1.7 percent year-on-year
By Lucia Mutikani
WASHINGTON, June 14 (Reuters) - U.S. retail sales in May recorded their biggest drop in 16 months and consumer prices unexpectedly fell, suggesting a softening in domestic demand that could limit the Federal Reserve’s ability to continue raising interest rates this year.
The Fed is expected to increase borrowing costs later on Wednesday, but the signs of moderate consumer spending and retreating inflation pressures could worry policymakers who have previously viewed the softness as transitory.
“It won’t stop the Fed from hiking interest rates later today, but it increases the downside risks to our forecast that there will be a further two rate hikes in the second half of this year,” said Paul Ashworth, chief U.S. economist at Capital Economics in Toronto.
The Commerce Department said retail sales fell 0.3 percent last month amid declining purchases of motor vehicles and discretionary spending after an unrevised 0.4 percent increase in April. May’s decline was the largest since January 2016 and confounded economists’ expectations for a 0.1 percent gain.
Retail sales rose 3.8 percent in May on a year-on-year basis. While some of the drop in monthly retail sales reflected lower gasoline prices, which weighed on receipts at service stations, details of the report were generally weak.
Excluding automobiles, gasoline, building materials and food services, retail sales were unchanged last month after an upwardly revised 0.6 percent rise in April. These so-called core retail sales correspond most closely with the consumer spending component of gross domestic product and were previously reported to have increased 0.2 percent in April.
Consumer spending accounts for more than two-thirds of the U.S. economy and last month’s weak core retail sales reading could temper expectations for a sharp acceleration in economic growth in the second quarter. The economy grew at a 1.2 percent annualized rate in the first quarter, held back by a near stall in consumer spending and a slower pace of inventory investment.
Output increased at a 2.1 percent pace in the October-December period. The Atlanta Fed is forecasting GDP rising at a 3.0 percent annualized rate in the second quarter.
In a separate report, the Labor Department said its Consumer Price Index dipped 0.1 percent, weighed down by declining prices for gasoline, apparel, airline fares, communication and medical care services, among others. The CPI rose 0.2 percent in April.
It was the second drop in the CPI in three months. In the 12 months through May, the CPI increased 1.9 percent, the smallest increase since last November. The CPI rose 2.2 percent in the 12 months through April.
The Fed has a 2 percent inflation target and tracks an inflation measure which is currently at 1.5 percent.
While the U.S. central bank is expected to raise interest rates by 25 basis points on Wednesday, the second hike this year, the weakness in inflation and retail sales, if sustained, could put further monetary tightening in jeopardy.
The dollar fell to a seven-month low against a basket of currencies on the data, while prices for U.S. Treasuries rose. U.S. stocks were trading slightly lower.
The year-on-year gain in the CPI in May was still larger than the 1.6 percent average annual increase over the past 10 years. Economists polled by Reuters had forecast the CPI unchanged last month and advancing 2.0 percent from a year ago.
The so-called core CPI, which strips out food and energy costs, rose 0.1 percent in May after a similar gain in April. The core CPI increased 1.7 percent year-on-year, the smallest rise since May 2015, after advancing 1.9 percent in April.
“It will be difficult to continue characterizing the recent inflation pullback as transitory,” said Chris Low, chief economist at FTN Financial in New York.
Last month, rental costs increased 0.3 percent, matching April’s gain. Owners’ equivalent rent of primary residence advanced 0.2 percent after a similar increase in April.
Gasoline prices recorded their largest drop since February 2016, while food prices rose for a fifth straight month.
In the retail sales report, auto sales fell 0.2 percent in May and receipts at service stations dropped by the most since February 2016.
Department store sales recorded their biggest drop since July 2016. Department store sales are being undercut by online retailers, led by Amazon.com. That has led some retailers, including Macy‘s, Sears and Abercrombie & Fitch to announce shop closures.
Sales at online retailers increased 0.8 percent last month after rising 0.9 percent in April. Sales at electronics and appliance stores suffered their largest drop since March 2010. Americans also cut back on spending at restaurants and bars, as well as at sporting goods and hobby stores.
Reporting by Lucia Mutikani; Editing by Andrea Ricci