WASHINGTON (Reuters) - US consumer prices rose briskly last month on energy costs, but outside volatile energy, inflation was largely contained, leaving room for the Federal Reserve to cut interest rates to bolster a slowing economy.

A second government report yesterday showed an unexpectedly steep rise in initial claims for jobless benefits last week, a suggestion the labor market is softening as the economy lumbers under the weight of a housing downturn, tighter credit and higher energy prices.

The Consumer Price Index, the most broadly used gauge of inflation, rose 0.3 percent in October for a second straight month as energy prices posted their biggest rise since May.

But core prices, which strip out volatile energy and food costs, rose a more modest 0.2 percent in October. Both the overall and core reading were in line with financial market expectations.

Core inflation was held in check by falling prices for new and used vehicles and household furnishings. Shelter costs, which make up almost a third of the price index, advanced more slowly than in recent months.

The moderate core inflation reading may give the Federal Reserve some breathing room as it decides whether further interest rate cuts are necessary to counter financial market turbulence and a worrisome housing downturn.

"The CPI data was 'tame' enough that it clears the way for the Federal Reserve to lower interest rates again," said Sean Broderick, an analyst at investment research firm Weiss Research, Inc. in Jupiter, Florida. Prices for US government bonds rose as traders saw the data providing the inflation-wary Fed some latitude to take interest rates lower. Stocks pared losses and the dollar rose against the euro but slipped against the yen.

After the data, markets were betting the likelihood of a Fed rate cut at the group's December meeting was 90 percent, up from 72 percent late on Wednesday.

Although policy-makers pay close attention to core inflation measures, the Fed signaled this week it will be paying more heed to overall inflation as it projects economic trends farther into the future.

"Ultimately, households and businesses care about the overall, or 'headline,' rate of inflation; therefore the (Fed) should refer to an overall inflation rate when evaluating whether the committee has met its mandated objectives over the long run," Fed chairman Ben Bernanke said in a speech on Wednesday.