WRAPUP 2-Weaker U.S consumer spending, rising inflation pose dilemma for Fed

(Adds details, analyst comments, markets)

* Consumer spending falls 0.6% in December

* Core PCE price index rises 0.5%; up 4.9% year-on-year

* Wages gain 1.1% in Q4; surge 4.5% year-on-year

WASHINGTON, Jan 28 (Reuters) - U.S. consumer spending fell in December, suggesting the economy lost speed heading into the new year amid snarled supply chains and raging COVID-19 infections, while annual inflation increased at a pace last seen nearly 40 years ago.

Wage inflation is also building up amid an acute shortage of workers. Private industry wages rose strongly in the fourth quarter, posting their largest annual gain since the mid-1980s, other data showed on Friday. Mounting inflation pressures could force the Federal Reserve to aggressively hike interest rates, stifling growth, economists warned.

"No one wants to go back to the 80s, but the economy is. Can stagflation from an overly aggressive Fed be next?" said Christopher Rupkey, chief economist at FWDBONDS in New York. "The Fed let its guard down and now they risk it all by saying they might have to move faster and higher on interest rates."

Consumer spending, which accounts for more than two-thirds of U.S. economic activity, dropped 0.6% last month after gaining 0.4% in November, the Commerce Department said. The decline was in line with economists' expectations.

The data was included in the advance gross domestic product report for the fourth quarter published on Thursday. The economy grew at a 6.9% annualized rate last quarter, accelerating from the July-September quarter's 2.3% pace. That helped to boost growth in 2021 to 5.7%, the strongest since 1984. The economy contracted 3.4% in 2020.

Consumer spending dropped in December likely as the result of Americans starting their holiday shopping in October for fear of empty shelves at stores because of rampant shortages of goods, including motor vehicles. Spending on goods fell 2.6%, led by automobiles.

Outlays on services gained 0.5%, lifted by healthcare.

Sky-rocketing coronavirus infections driven by the Omicron variant slowed the improvement in supply chains, with workers calling in sick. Worsening shortages kept inflation elevated last month.

The personal consumption expenditures (PCE) price index excluding the volatile food and energy components, rose 0.5% after a similar gain in November. The so-called core PCE price index accelerated 4.9% year-on-year in December, the biggest rise since September 1983. The core PCE price index increased 4.7% in the 12 months through November.

Stocks on Wall Street were lower. The dollar was steady against a basket of currencies. U.S. Treasury prices rose.

WAGE PRESSURES GROWING

Inflation is running way above the Fed's flexible 2% target. The U.S. central bank on Wednesday said it was likely to raise interest rates in March.

Bank of America Securities is predicting seven rate hikes this year. JPMorgan on Friday raised its forecast to five rate increases from four.

"The challenge now is to tamp down inflation without allowing the flame on the overall economy to go out," said Diane Swonk, chief economist at Grant Thornton in Chicago. "There is no road map for doing this after inflation has surged."

Signs that inflation could remain stubbornly high were reinforced by a separate report from the Labor Department on Friday showing the Employment Cost Index, the broadest measure of labor costs, rose 1.0% in the fourth quarter after increasing 1.3% in the July-September period.

Labor costs surged 4.0% on a year-on-year basis, the largest rise since the fourth quarter of 2001, after increasing 3.7% in the third quarter.

The ECI is widely viewed by policymakers as one of the better measures of labor market slack and a predictor of core inflation as it adjusts for composition and job quality changes.

The labor market is viewed as being at or near maximum employment. There were 10.6 million job openings at the end of November.

Wages and salaries rose 1.1% last quarter after increasing 1.5% in the third quarter. They were up 4.5% year-on-year, the largest increase since the second quarter of 1990. Private industry wages rose 1.2% and shot up 5.0% year-on-year, the most since the first quarter of 1984. Benefits for all workers rose 0.9% after a similar gain in the July-September quarter.

But high inflation is cutting into wage gains, eroding consumers' purchasing power. The rising cost of living and pandemic fatigue pushed consumer sentiment back to a 10-year low in January.

The report from the Commerce Department showed consumer spending adjusted for inflation dropped 1.0% in December after slipping 0.2% in November.

The decline in the so-called real consumer spending set consumption on a slower growth trajectory heading into the first quarter, which could pull overall economic growth lower.

Consumer spending rose at a 3.3% rate last quarter. Growth forecasts for the first quarter are so far below a 2% rate, with some economists predicting an outright decline in output.

Still, growth is expected to rebound by the second quarter as the current Omicron wave of infections subsides and supply constraints ease. Consumers are sitting on more than $2 trillion in excess savings accumulated during the pandemic.

It is, however, unclear when and how much of these savings will be spent. Economists also note that the bulk of the savings are by higher income households, who tend to be savers and some of the money could go towards retirement.

"To our minds, despite the strength of price and wage inflation, it is disappointingly weak real economic growth that will prevent the Fed from delivering a full-blown Ratemaggedon this year," said Paul Ashworth, chief U.S. economist at Capital Economics in Toronto. (Reporting by Lucia Mutikani Editing by Chizu Nomiyama)