TREASURIES-Longer-dated prices rise in low inflation scenario

* PPI index posts biggest monthly drop in seven months

* 2Y-10Y part of yield curve flattest since end-2009

* Trade volume thin, prices within recent ranges (Adds economist's quote, updates prices, changes byline)

By Chris Reese

NEW YORK, March 17 (Reuters) - Longer-dated U.S. Treasuries rose on Wednesday as a hefty drop in producer prices was taken by investors as further evidence the Federal Reserve will not raise rock-bottom interest rates any time soon.

Prices gains were limited, however, as higher stocks eroded the safe-haven appeal of lower-risk government debt.

Bonds rose early in the day after the government reported the producer price index in February dropped 0.6 percent, more than expected and the biggest decline in seven months. For details see [ID:nN17150095].

The PPI reading reinforced the notion that inflation is a remote threat to the U.S. economy and supported the view that consumers face little price pressure.

"It is only over the next year or so that the true disinflationary pressure of the recession will start to be felt -- such trends will force the Fed to keep interest rates on hold for much longer than the markets expect," said Paul Dales, U.S. economist at Capital Economics in Toronto.

Benchmark 10-year Treasury notes US10YT=RR traded 3/32 higher in price to yield 3.64 percent, down from 3.65 percent late Tuesday, while two-year notes US2YT=RR were unchanged in price to yield 0.92 percent.

The spread between yields on 10-year notes and two-year notes, a gauge of the market's inflation expectations, narrowed to 272 basis points, the tightest so far this year.

Moreover, the yield gap between the regular 10-year note and 10-year Treasury Inflation-Protected Securities held steady at about 2.24 percent, signaling investors expect long-term inflation will stay tame.

Treasuries had gained on Tuesday after the Fed reaffirmed its pledge to keep short-term interest rates near zero for an extended period in an effort to support the economic recovery.

Trade volume was below average, according to data from ICAP, and prices hovered well within recent ranges.

"There is no compelling reason to move out of this range. The Fed didn't give us anything new," said Jeff Given, portfolio manager at MFC Global Investment in Boston.

Treasuries buying was capped on Wednesday in part by strength in the stock markets. The Dow industrials rose for the seventh consecutive day to finish at a 17-month high. [.N]

Investors will have more information on the state of inflation on Thursday, when the government releases its consumer price index for February.

Meanwhile, five-year Treasury notes US5YT=RR traded 2/32 lower in price to yield 2.37 percent, up from 2.36 percent late Tuesday, while 30-year bonds US30YT=RR_traded 13/32 higher to yield 4.57 percent from 4.59 percent. (Additional reporting by Richard Leong; Editing by Leslie Adler)