Despite record gas, inflation tame

NEW YORK (CNNMoney.com) -- Prices paid by consumers rose faster in May, fueled by record gasoline prices, but when food and energy prices were stripped out, the government's key inflation measure came in below Wall Street expectations.

Overall, prices at the retail level rose 0.7 percent in the month, compared to a 0.4 percent gain in April, according to the Labor Department's Consumer Price Index. Economists surveyed by Briefing.com had forecast a 0.6 percent rise in May.

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Much of the jump in prices came because of a 10.5 percent one-month spike in gasoline prices that lifted overall energy prices 5.4 percent in the month.

But gasoline prices have already retreated since the May inflation readings were taken. A survey of 85,000 gas stations conducted daily on behalf of AAA shows the current average price of a gallon of unleaded down 6.1 percent since hitting a record May 24.

That spike in May gas prices, followed by the retreat, means that more than ever, the most closely watched part of this report is the so-called core CPI, which strips out volatile food and energy prices. And core CPI rose 0.1 percent in May, compared to the 0.2 percent increase in April. Economists had forecast another 0.2 percent gain.

The increase left the core CPI up 2.2 percent over the last 12 months, which is less than the previous reading of a 2.3 percent year-over-year climb. That puts it closer to the range of a 1 to 2 percent rise in the core CPI that is generally believed to be within the Federal Reserve's comfort zone.

It is the lowest 12-month change in the core since March 2006. As recently as February of this year, the year-over-year change in core CPI had been as high as 2.7 percent.

"It certainly makes the Fed happy," said David Wyss, chief economist for Standard & Poor's. "Everything is coming up roses from their standpoint. They've got the economy right where they wanted."

Rich Yamarone, director of economic research at Argus Research, said he's surprised that inflation pressures aren't greater in both the overall reading and the core. But he said the higher food prices in the report, up 0.3 percent for the month, could cause problems down the road.

"I don't think there's a problem with inflation right now, but I don't think we're out of the woods yet," he said. "I suspect down the road we'll see higher food and energy leach into the core."

Mark Vitner, senior economist with Wachovia, said the report shows that the current outlook for better growth is doing little to raise inflation pressure.

"This is better than a Goldilocks economy," he said.

The economists agreed that the report leaves the Fed in position to leave rates unchanged through at least the end of the year.

"They feel like they could cut if they needed to but I don't think they believe they need to," said Wyss.

Treasury prices rose sharply on the report, as the yield on the 10-year note fell to 5.18 percent after the report from 5.23 percent just before the report.

Separate reports that showed slower than expected industrial production in May and a drop in consumer confidence in June to a 10-month low also worked to tamp down bond yields.

U.S. stocks rose in morning trading, as futures shot up immediately following the report an hour before the market open.