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(Adds factory data, analyst comments, updates markets)
* Employment cost index rises 0.6% in second quarter
* Wages, salaries gain 0.7%; benefits up 0.5%
* Private payrolls increase 156,000 in July
* Midwest factory activity contracts again in July
WASHINGTON, July 31 (Reuters) - U.S. labor costs rose at their slowest pace in 1-1/2 years in the second quarter, the latest indication of benign inflation that could allow the Federal Reserve to cut interest rates on Wednesday for the first time in a decade.
Other data on Wednesday suggested a further slowdown in economic growth at the start of the third quarter. Manufacturing activity in the Midwest contracted for a second straight month in July, declining to its lowest level in more than 3-1/2 years.
While private payrolls rebounded this month, the pace of growth remained moderate, adding to the host of factors that are likely to encourage the Fed to announce its first rate cut since 2008 when policymakers conclude a two-day meeting at 2 p.m. EDT (1800 GMT).
The 10-year economic expansion, the longest in history, is facing headwinds from a bitter trade war between the United States and China, slowing global growth and Britain's potential disorderly departure from the European Union.
The Employment Cost Index, the broadest measure of labor costs, increased 0.6% in the second quarter, the smallest gain since the fourth quarter of 2017, the Labor Department said. The ECI had increased 0.7% for two straight quarters.
In the 12 months through June, the ECI rose 2.7%, slowing from a 2.8% increase in the year through March.
Economists polled by Reuters had forecast the ECI would rise 0.7 percent in the April-June period.
The ECI is widely viewed by policymakers and economists as one of the better measures of labor market slack. It is also considered a better predictor of core inflation. Labor costs picked up over 2018 as a tightening labor market pushed up wage growth. The pace of increases has since moderated somewhat despite the unemployment rate being near a 50-year low.
"The historical relationship between the unemployment rate and wage growth seems to have weakened somewhat during this business cycle, however, leading us to expect only measured incremental improvements in wage pressures," said Blerina Uruci, an economist at Barclays in Washington.
The report came on the heels of data on Tuesday showing a key measure of inflation increased 1.6% in the 12 months to June, continuing a pattern of slow gains that have seen it undershoot the Fed's 2% target this year.
In the second quarter, wages and salaries, which account for 70 percent of employment costs, rose 0.7% after rising by the same margin in the prior period. Wages and salaries were up 2.9% in the 12 months through June, matching the gain in the year through March.
Private sector wages and salaries rose 0.6% in the second quarter after increasing 0.7% in the first quarter. They were up 3.0% in the 12 months through June after rising by the same margin in the year through March.
The dollar was little changed against a basket of currencies as traders awaited the Fed's decision on rates. U.S. Treasury prices rose marginally. Stocks on Wall Street were trading slightly higher, lifted by upbeat earnings from Apple .
The economy is losing speed largely as the stimulus from last year's $1.5 trillion tax cut package fades. That loss of momentum was underscored by a second report on Wednesday showing the Chicago Business Barometer fell to 44.4 in July, the lowest reading since December 2015, from 49.7 in June.
The index is jointly developed by MNI Indicators and ISM-Chicago. A reading below 50 indicates a contraction in manufacturing in the Midwest region. Automobiles account for a large portion of the index. The auto sector is struggling with slow sales and an inventory bloat.
The survey's production measure plunged to a 10-year low. A measure of new orders received by factories contracted further and firms continued to accumulate inventories. The gauge of factory employment contracted for the first time since October 2017 and hit the lowest level since October 2009.
Coming on the heels of other weak July regional factory surveys, this month's drop poses a downside risk to the closely watched Institute for Supply Management (ISM) national manufacturing index.
The July ISM index is scheduled to be released on Thursday. According to a Reuters survey of economists, the ISM manufacturing index likely rose to a reading of 52.0 in July from 51.7 in June.
"The extreme weakness in July's Chicago PMI points to a weaker-than-expected manufacturing ISM tomorrow," said Chris Low, chief economist at FTN in New York.
Manufacturing, which accounts for about 12% of the economy, is being undercut by an inventory overhang, trade tensions, weakening global growth and design problems at aerospace giant Boeing.
The troubles in manufacturing are contributing to slower job growth. The ADP National Employment Report showed private payrolls increased by 156,000 jobs in July after rising 112,000 in June. The ADP report, which is jointly developed by Moody's Analytics, was released on Wednesday, two days ahead of the government's more comprehensive employment report.
Nonfarm payrolls likely increased by 162,000 jobs in July, according to a Reuters survey, after surging by 224,000 in June. Job gains averaged 172,000 per month in the first half of this year, below the monthly average of 223,000 in 2018.
The pace of job gains, however, remains above the roughly 100,000 per month needed to keep up with growth in the working-age population. The unemployment rate is expected to have held steady at 3.7% in July. (Reporting by Lucia Mutikani Editing by Paul Simao)