Rising food and gasoline costs lifted U.S. consumer prices overall in March, but underlying inflation pressures were contained and consumers grew more confident about the economy in early April.

Consumers' expectations of inflation in the longer term also fell as higher energy and food costs were seen as probably temporary.

The small rise in core inflation, excluding food and energy costs, and the moderation in long-term inflation expectations may be seen as vindication for officials at the Federal Reserve who have viewed the recent energy price spike as having a temporary effect on inflation.

This should help to ease inflation concerns at the Fed. With food and energy cutting into consumer spending power, it's difficult for sellers of other goods and services to pass price increases through to the consumer, said Nigel Gault, chief U.S. economist at IHS Global Insight in Lexington, Massachusetts.

The Fed's policy-setting committee meets April 26-27 and debate is most likely to focus on the timing of the withdrawal of some of the massive stimulus it has lent to the economy.

Overall consumer inflation rose 0.5 percent in March after increasing by the same margin in February, the Labor Department said on Friday.

But the core consumer price index, watched by the U.S. central bank as a guide to monetary policy, edged up 0.1 percent after rising 0.2 percent in February. Economists had expected core CPI to gain 0.2 percent in March.

Consumers' one-year inflation expectation was steady at 4.6 percent, but their expectations for the next five to 10 years fell to 2.9 percent in April from 3.2 percent in March.

Inflation expectations are viewed as a transmission channel for price pressures and Fed officials have said they would monitor them to ensure an inflation mentality does not become ingrained.

In other data, the Thomson Reuters/University of Michigan's index on consumer sentiment rose to 69.6 in early April from 67.5 in March, above expectations for a reading of 68.5.

The economic data offset disappointing results from Bank of America Corp and Google, giving U.S. stocks a lift. U.S. Treasuries rallied on the inflation data.

INFLATION PRESSURES CONTAINED

Year-on-year consumer prices rose 2.7 percent, the largest gain since December 2009, after increasing 2.1 percent in February. But in the 12 months through March, core CPI rose only 1.2 percent, well below the Fed's preferred level of 2.0 percent, after advancing 1.1 percent in February.

Chicago Fed President Charles Evans said on Friday March's consumer inflation report was in line with low underlying inflation.

While the data suggested that inflation pressures remained contained, most economists believe the Fed will strike a slightly more hawkish tone at the month-end meeting, citing another report that showed industrial capacity use jumped in March to its highest level since August 2008.

It shows that in this segment of the economy the pace of slack absorption is much faster than anticipated, certainly there will be price pressures coming from there, said Millan Mulraine, a senior macro strategist at TD Securities in New York.

The rise in industrial capacity utilization came as industrial output rose 0.8 percent in March on a rebound in the utilities sector and continued vigor in manufacturing, which has anchored the recovery.

Drawing parallels with previous downturns, economists said when industrial capacity utilization reached cyclical highs in 2004, the Fed raised interest rates for the first time after the 2001 recession.

It's going to be very difficult for those (doves) on the committee to argue -- they can and they will and have the debate points on their side -- but for the moment, the evidence is clearly on the side of the hawks that it's time to start draining the punch bowl, said Steve Blitz, a senior economist at ITG Investment Research in New York.

One of the Fed's most consistent monetary policy hawks, Kansas City Fed President Thomas Hoenig said on Friday the central bank should not wait too long before raising benchmark lending rates, but should not raise them too fast.

HOURLY EARNINGS FALL

But with depressed wages making it tough for businesses to raise prices on a large scale, the monetary policy doves have a little more time. Real average hourly earnings fell 0.6 percent in March after declining 0.5 percent the previous month.

Food and gasoline prices accounted for almost three- quarters of the rise in overall consumer inflation last month. Gasoline rose 5.6 percent, increasing for a ninth straight month, and the index has now risen 14.4 percent over the last three months.

Food rose 0.8 percent, the largest gain since July 2008, after increasing 0.6 percent in February.

In the calculation of core inflation, shelter costs rose for a sixth straight month, another factor economists said would determine the tone of future Fed statements.

Shelter costs, which account for about 40 percent of core CPI, have suppressed underlying inflation pressures.

There were also increases in new and used vehicle prices, air fares and medical costs. Apparel prices fell 0.5 percent after dropping 0.9 percent in February.

(Additional reporting by Tim Ahmann; Editing by Jan Paschal)

Inflation