U.S. job growth accelerated in May and the unemployment rate dropped to an 18-year low of 3.8%, pointing to rapidly tightening labor market conditions, which could stir concerns about inflation.

Nonfarm payrolls surged by 223k jobs last month as warm weather bolstered hiring at construction sites. There were also big gains in retail and leisure and hospitality payrolls. The economy created 15k more jobs than previously reported in March and April.

Last month's one-tenth of a percentage point drop in the unemployment rate pushed it to a level last seen in April 2000. The jobless rate is now where the Fed forecast it would be by the end of this year.

Average hourly earnings rose eight cents, or 0.3% last month after edging up 0.1% in April. That pushed the annual increase in average hourly earnings to 2.7% from 2.6% in April.

The strong employment report added to a string of upbeat economic data, including consumer spending, industrial production and construction spending, that have suggested economic growth was regaining speed early in the second quarter after expanding at a moderate 2.2% annualized rate in the January-March period.

The Atlanta Fed is forecasting GDP rising at a 4.8% pace in the second quarter. The strength comes even as the stimulus from a USD 1.5 trillion income tax cut package and increased government spending is yet to be felt.

The U.S. central bank lifted borrowing costs in March and forecast at least two more rate increases for this year. Inflation is running just below the Fed's 2.0% target. But we think that the political tensions in Europe and a protectionist domestic trade policy could dissuade the Fed from taking a more hawkish stance when policymakers meet on June 12-13. Traders, however, raised bets for four rate hikes this year.

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