By Howard Schneider

WASHINGTON (Reuters) -Federal Reserve officials met on Tuesday armed with new economic data that could give more weight to their concerns that Trump administration policies, or at least the intense uncertainty around them, will slow growth in the coming months.

Shortly before the start of the two-day policy meeting, the U.S. Commerce Department reported that U.S. retail sales fell 0.9% in May, exceeding the expected 0.7% decline in a Reuters poll of economists and marking the biggest drop in four months. The U.S. central bank itself then released a report showing a surprise contraction in industrial production last month.

The data, however, was hardly clear-cut.

The retail sales report, with revisions also showing a small drop in April, was heavily influenced by slower auto sales after a surge earlier in the year driven by consumers hoping to avoid 25% levies on imported vehicles. Bad weather may have also been an influence, said Bradley Saunders, a North America economist at Capital Economics, with sales of an underlying group of goods more closely related to broader economic conditions suggesting "overall consumption continues to look healthy."

The 0.2% drop in industrial production, however, pushed overall capacity utilization down 77.4%, its lowest level since January.

A separate survey showed sentiment among homebuilders slid to the lowest point in two and a half years amid weak demand among buyers and high financing costs, a factor tied to monetary policy and the Fed's reluctance to reduce interest rates any further until it is clear that President Donald Trump's tariff policies won't lead to a persistent increase in inflation. 

Recent inflation data has been tame despite rising tariffs, but the Fed is still trying to reduce the pace of price increases to 2% after it surged in the years following the COVID-19 pandemic - with tariff-driven price hikes still seen as on the way.

The risk of rising prices remains a dominant concern for the central bank despite signs the economy overall may be slowing. Trump's final tariff plans remain unclear, with trade deals promised but still not done with dozens of nations he has threatened to tax, and one-off proposals to levy specific goods like appliances that may or may not be implemented.

Ongoing hostilities between Iran and Israel, meanwhile, have boosted the price of oil, another risk the Fed must contend as it prepares to release on Wednesday a new policy statement and updated policymakers' economic and interest rate projections.

James Knightley, chief international economist at ING, noted that the retail sales data is not adjusted for inflation, and the drop, once accounting for price rises, "paints a weak picture that reflects subdued consumer confidence readings. Households are nervous that tariff-induced price hikes will squeeze spending power while respondents have become much more cautious on job prospects, and this suggests that consumer spending will continue to cool through this year."

How to balance the risk of slowing growth against the risk of anticipated higher inflation will be at the center of Fed policymakers' debate on Tuesday and Wednesday, along with likely discussion of the implications of the crisis in the Middle East.

FED FORECASTS

The U.S. central bank is widely anticipated to leave its benchmark overnight interest rate in the 4.25%-4.50% range, where it has been since December, and repeat that it can't give much guidance until it is clearer whether Trump's import tariffs and fiscal policies push inflation higher, undercut growth, or - as his administration contends will happen - keep growth on track while prices ease. Trump has demanded immediate rate cuts.

Days of intense missile exchanges between Israel and Iran, however, have presented the Fed with even more reason for caution after oil prices jumped again on Tuesday and presented a possible new source of inflation.

The conflict highlights the uncertainty Fed officials say has gripped their policy debate since Trump returned to power in January and unveiled a far more aggressive effort than expected to raise import taxes and rewrite global trade rules.

Fed officials and many economists have largely expected that Trump's trade policies will have a stagflationary effect on the U.S. economy, simultaneously slowing growth and raising prices, with the monetary policy path - whether rate cuts or an extended hold of borrowing costs at the current level - dependent on which problem seems to be more serious.

The Fed will issue a new policy statement as well as updated projections for the economy and the benchmark interest rate at 2 p.m. EDT (1800 GMT) on Wednesday, with Fed Chair Jerome Powell scheduled to hold a press conference half an hour later.

The central bank's Summary of Economic Projections may draw more attention than the policy decision itself, as analysts and investors look for evidence of how Fed officials' views of the outlook have changed since their last set of projections in March, before the scope of Trump's tariff plans became clear but also before he delayed some of the stiffest levies in the face of largely negative market reaction.

Fed officials in March marked down their expectations for economic growth this year and raised their level of expected inflation, but left unchanged the median outlook for two quarter-percentage-point rate cuts this year. Though that rate outlook matched the one in December, the spread of views in the Fed's "dot plot" chart narrowed, and some analysts anticipate a further hawkish shift in light of the central bank's emphasis on keeping inflation controlled and expectations that Trump's new tariffs still will lead to price increases.

"Trade policy developments have likely led to a significant change in Fed forecasts," towards even slower growth and higher inflation this year than expected as of March, Michael Feroli, chief U.S. economist at JP Morgan, wrote on Friday.

"These stagflationary revisions don't point to a clear direction of the revision to the dots. Even so, we think the dots will revise in a modestly hawkish direction" with only a single rate cut this year.

(Reporting by Howard Schneider; Editing by Paul Simao)