WASHINGTON (Reuters) - U.S. labor costs increased moderately in the second quarter as private sector wages grew at the slowest pace in 3-1/2 years, more evidence that inflation was firmly on a downward trend and could help facilitate an interest rate cut in September.

The report from the Labor Department on Wednesday followed data last week showing inflation subsided considerably last quarter, with sub-3% readings in all the measures. Labor costs are likely to cool further as the jobs market continues to ease.

The modest rise in labor costs is likely to be welcomed by Federal Reserve officials who are wrapping up a two-day policy meeting on Wednesday. The U.S. central bank is expected leave its benchmark overnight interest rate in the 5.25%-5.50% range, where it has been since last July.

"Wages and salary increases in private industry are more in line with where Fed officials would like it to be," said Christopher Rupkey, chief economist at FWDBONDS in New York. "The economy is gradually returning to normal. Cooler wages give the green light to Fed rate cuts."

The employment cost index (ECI), the broadest measure of labor costs, increased 0.9% last quarter after rising by an unrevised 1.2% in the first quarter, the Labor Department's Bureau of Labor Statistics said.

Economists polled by Reuters had forecast the ECI would rise 1.0%. Labor costs advanced 4.1% in the 12 months through June, the smallest gain since the fourth quarter of 2021, after climbing 4.2% in the year through March. Annual labor cost growth has slowed from 4.5% in June 2023.

The ECI is viewed by policymakers as one of the better measures of labor market slack and a predictor of core inflation because it adjusts for composition and job-quality changes. The U.S. central bank has a 2% inflation target.

"Today's data mark an important step toward the Fed gaining 'greater confidence' that inflation is cooling sufficiently to begin reducing the fed funds rate," said Sarah House, a senior economist at Wells Fargo.

Price pressures are ebbing following 525 basis points worth of rate hikes from the Fed since 2022. The government reported on Tuesday that job openings maintained their steady decline in June and hires dropped to the lowest level since 2020.

Stocks on Wall Street were trading higher. The dollar fell against a basket of currencies, including the yen after the Bank of Japan raised rates to the highest since 2008. U.S. Treasury yields fell.

HEALTH BENEFITS RISE

Wages and salaries, which account for the bulk of labor costs, increased 0.9% last quarter. That was the smallest advance in three years and followed a 1.1% rise in the January-March quarter.

They increased 4.2% on an annual basis, slowing from 4.4% in the first quarter. When adjusted for inflation, overall wages gained 1.2% in the 12 months through June after rising 0.9% in the first quarter. That helped to boost consumer spending and overall economic growth last quarter.

Private sector wages and salaries climbed 0.8%, the smallest advance since the fourth quarter of 2020, after rising 1.1% in the January-March quarter. They increased 4.1% in the 12 months through June after rising 4.3% in the first quarter.

Wages and salaries for union workers increased 6.5%, and rose 3.8% for non-union workers.

The construction industry recorded a quarterly drop in wages, while the gains in manufacturing slowed. In the services sector, solid increases were reported in the retail, finance and insurance and utilities industries.

Wages in the information industry almost stalled and fell in the wholesale trade sector.

The slowdown in wage gains was corroborated by the ADP employment report on Wednesday showing salaries for workers staying in their jobs rising 4.8% year-on-year in July, the smallest increase in three years.

With fewer workers quitting their jobs in search of greener pastures, wage inflation is likely to continue trending lower.

State and local government wage gains also slowed, rising 1.1% after shooting up 1.4% in the first three months of the year. They, however, continued to run higher on an annual basis, advancing 5.1% after increasing 5.0% in the 12 months through March.

Benefits for all workers rose 1.0% after increasing 1.1% in the January-March quarter. They increased 3.8% in the 12 months through June after advancing 3.7% in the first quarter. Health benefits for private workers surged 3.6% on a year-on-year basis after rising 2.8% in the first quarter.

There was some encouraging news on the struggling housing market. A report from the National Association of Realtors showed contracts to buy previously owned homes rebounded 4.8% in June amid improving supply after declining 1.9% in May. This, however, unlikely signals a sharp turnaround as affordability remains a challenge.

Contracts, which lead existing home sales by a month or two, dropped 2.6% in June on a year-on-year basis.

"Elevated mortgage rates and high prices will be headwinds for buyers in the near term," said Rubeela Farooqi, chief U.S. economist at High Frequency Economics. "But rising inventories and lower borrowing costs as the Fed starts to lower interest rates should be positive for home sales over time."