Aug. 4 (Bloomberg) -- The biggest increase in prices in almost three years eroded consumers' buying power, reinforcing speculation the Federal Reserve won't raise interest rates in the face of faster inflation and slow growth.

Consumer inflation in June climbed 0.8 percent, the most since September 2005, the Commerce Department said today in Washington. Spending increased 0.6 percent, more than forecast, compared with a gain of 0.8 percent the prior month. Price jumps in petroleum and chemicals also swelled the value of orders to American factories in June.

Tax rebates from $168 billion in fiscal stimulus will provide only a temporary boost for Americans facing $4 a gallon gasoline and unemployment at the highest level since 2004. Fed officials, meeting tomorrow, must find a way to acknowledge the risk of accelerating inflation without signaling a rate increase that would worsen the economic slowdown, economists said.

``There is a bit more inflation pressure than many people anticipated,'' said Kevin Logan, a senior market economist at Dresdner Kleinwort in New York, who correctly forecast the gain in spending. ``Inflation pressure is more widespread and that has to be some concern for the Fed.''

The Fed's preferred gauge of prices, which excludes food and fuel, climbed 0.3 percent, more than economists forecast.

Treasuries fell after the reports and stocks dropped. The yield on the benchmark 10-year note was 3.96 percent at 4:17 p.m. in New York, up from 3.93 percent late on Aug. 1. The Standard & Poor's 500 Index dropped 11.3 points, or 0.9 percent, to close at 1,249.01.

Focus on Language

``I'd expect more hawkish language from the Fed tomorrow because of where inflation is, but I don't expect a change in the policy rate,'' said Adam York, an economist at Wachovia Corp. in Charlotte, North Carolina. ``The economy is fairly weak, there are ongoing problems in financial markets and there's not a whole lot of support for consumer spending after the rebate checks are spent.''

Economists had forecast spending would rise 0.4 percent, after an originally reported 0.8 percent increase in May, according to the median of 67 estimates in a Bloomberg News survey. Projections ranged from a 0.5 percent decline to a 0.9 percent gain.

The core inflation rate exceeded economists' forecasts for an increase of 0.2 percent, according to the median estimate in the Bloomberg survey. The price measure was up 2.3 percent from June 2007, the biggest year-over-year increase since December.

European Scene

Price pressures are also building in Europe, where producer prices rose the most in at least 18 years in June on soaring energy costs. The 8 percent increase from a year ago in factory prices in the 15 nations that use the euro was the biggest since the series began in 1990, the European Union statistics office in Luxembourg said today.

U.S. incomes increased 0.1 percent after jumping 1.8 percent the prior month, today's report showed. The median forecast was a decline of 0.2 percent. About $28 billion in rebates went out in June, compared with about $50 billion in late April and May, according to Treasury Department figures.

Investors are betting the Fed will hold the benchmark rate unchanged at 2 percent tomorrow, according to federal funds futures contracts. Fed Chairman Ben S. Bernanke on July 15 told lawmakers that the economy faced threats to both growth and inflation.

Adjusted for inflation, spending decreased 0.2 percent after rising 0.3 percent in May.

Factory Orders

A separate Commerce Department showed factory orders in the U.S. increased more than forecast in June, propelled by gains in petroleum and chemicals that reflected soaring prices. The 1.7 percent gain in bookings to $457.6 billion was the biggest jump this year, the report showed.

``These numbers are somewhat inflated by prices, maybe even outside of petroleum,'' said David Sloan, senior economist at 4Cast Inc. in New York. ``The underlying picture is fairly flat'' for manufacturing.

A private report showed planned job cuts by U.S. employers soared last month.

Firing announcements increased to 103,312 last month, up 141 percent from 42,897 in July 2007, Chicago-based Challenger, Gray & Christmas Inc. said in a statement today. It was the biggest year-over-year percentage increase since November 2001, at the end of the last official recession.

Rebate Benefit Fades

Most economists are forecasting the lift from the rebates will fade in the second half of the year. Purchases of autos and light trucks dropped in July to the lowest level since 1993, industry figures last week showed.

Economists surveyed by Bloomberg in the first week of July forecast economic growth to slow to 1.4 percent in the third quarter and to 0.5 percent in the fourth quarter. The Labor Department last week said U.S. nonfarm payrolls fell by 51,000 in July, bringing the total payroll reductions so far this year to 463,000.

The economy shrank at a 0.2 percent pace in the last three months of 2007 and grew at about an average 1.5 percent annual pace in the first six months of 2008, government data last week showed.

With the economy on the brink of a recession, consumers are focusing their purchases on staples while cutting back on luxuries like $4 lattes, causing sales to slump at Starbucks Corp. the world's largest chain of coffee shops.

Starbucks last week said it will close more U.S. stores than it will open next year after it posted its first loss in 16 years as a public company.

``Until the economy significantly improves, we're just trying to do what we can to get through this storm,'' Starbucks Chairman Howard Schultz said on a conference call.

To contact the reporter on this story: Bob Willis in Washington at bwillis@bloomberg.netShobhana Chandra in Washington at Schandra1@bloomberg.net

Last Updated: August 4, 2008 16:21 EDT