Inflation soars; home builder sentiment crumbles

By Burton Frierson

NEW YORK (Reuters) - Inflation accelerated in June to its fastest rate since the aftermath of Hurricane Katrina in 2005 while workers' earnings slumped, compounding the stagflationary dilemma facing the Federal Reserve.

A separate report showed U.S. homebuilder sentiment dropped to a record low in July, a reminder of the troubled housing market's drag on the economy, while the minutes from the Fed's latest policy meeting highlighted increasing worries over inflation amid an uncertain outlook for growth.

The Consumer Price Index, the government's key measure of inflation, advanced 1.1 percent during the same month, the biggest monthly rise since September 2005, when devastation from Hurricane Katrina drove energy prices up sharply.

Compared with a year ago, prices were up 5 percent, the biggest year-on-year rise since 1991. The worries over inflation, particularly after the Fed minutes, led investors to raise bets on future interest-rate rises by the central bank.

Coupled with data in the inflation report showing real weekly earnings fell 0.9 percent in June, the figures heightened fears that the U.S. economy could be entering a stagflationary period of low growth and high inflation.

"The report underscores the stagflationary environment we are in right now, which is not good for the dollar," said Stephen Malyon, senior currency strategist at Scotia Capital in Toronto. "There is so much uncertainty in the market right now that news of higher inflation doesn't mean a rise in interest rates."

U.S. industrial output unexpectedly rose in June, but analysts did not see this as the start of a long-lasting manufacturing recovery.

The NAHB/Wells Fargo Housing Market index fell to a record low 16 in July from 18 in June, the group said in a statement. Readings below 50 mean more builders view market conditions as poor than favorable.

Fed policy makers fretted at their June 24-25 meeting that increasing inflation risks might prompt the need for an interest-rate hike, but agreed that the outlook for both prices and growth was still too uncertain, minutes of the meeting showed.

DAY TWO

Fed Chairman Ben Bernanke, in his second day of congressional testimony, told the U.S. House Financial Services Committee his top priority was restoring calm to U.S. financial markets while weak growth and inflation threaten the economy.

Officials at the Fed -- the U.S. central bank -- have said they are keeping a close eye on inflation expectations.

The 5 percent annual inflation rate in Wednesday's data is very close to the 5.3 percent one-year inflation expectation in this month's Reuters/University of Michigan consumer sentiment report. However, Fed officials stress that long-term expectations are currently running lower, at 3.4 percent.

On Wall Street, stocks <.DJI><.IXIC><.SPX> gained as a sharp drop in oil prices lessened worries over the price pressures hitting consumers and companies. The dollar <.DXY>gained and prices of government bonds, which suffer during periods of high inflation, fell.

GLIMMER OF HOPE

U.S. mortgage applications rose for a third consecutive week, reflecting an increase in demand for home loan refinancing as interest rates plunged, The Mortgage Bankers Association said.

In soothing news from the beleaguered financial sector, Wells Fargo & Co , the fifth-largest U.S. bank, reported better-than-expected quarterly results on Wednesday and raised its dividend despite a 23 percent drop in profit caused by a surge in bad loans.

The Treasury Department said net overall U.S. capital flows reversed sharply to show outflows of $2.5 billion in May after a revised inflow of $61.6 billion in April -- a potentially troubling sign for the dollar if it were to continue.

(Additional reporting by Gertrude Chavez-Dreyfuss; Editing by Jan Paschal)

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