Weak retail and factory data stir recession fear

WASHINGTON (Reuters) - U.S. retail sales last month dropped the most in more than three years while a measure of New York state manufacturing hit its lowest since the index started in 2001, intensifying recession fears and punishing stocks.

A wholesale inflation index eased, suggesting the Federal Reserve has room to lower benchmark interest rates further to try to prop up an increasingly shaky U.S. economy, but that did little to dispel the gloom.

Retail sales fell 1.2 percent in September, the Commerce Department said on Wednesday The decline, the third consecutive monthly drop, was the sharpest since August 2005 and far greater than the 0.7 percent dip economists had expected.

"We have an all-out consumer retrenchment under way," said Richard DeKaser, chief economist at National City Corp in Cleveland.

The Labor Department said the producer price index, a gauge of prices received by farms, factories and refineries, dropped 0.4 percent in September, as a further fall in energy costs eased price pressures.

With the economy on weak ground and inflation cooling, investors bet on further interest-rate reductions from the Fed -- the U.S. central bank -- on top of the 3.75 percentage points in cuts it has already made in the past 13 months.

Fed Chairman Ben Bernanke, speaking in New York, warned that the economy was facing a "significant threat" from credit-market turmoil and said a recovery would not be swift even if aggressive government measures stabilized markets.

"We will continue to use all the tools at our disposal to improve market functioning and liquidity," he said.

The data spooked equities markets and losses grew after Bernanke provided his downbeat economic assessment. The broad Standard and Poor's 500 Index .SPX plunged 9 percent, its worst one-day drop since the 1987 stock market crash.

U.S. government debt prices rose as investors flocked to their relative safety and betting on rate cuts grew.

"The question on everyone's minds is how deep of a recession (will there be)," said Kathy Lien, director of currency research at GFT Forex in New York.

INFLATION PIPELINE

Falling oil prices cooled overall inflation, but a closely watched measure of prices that strips out food and energy costs posted a surprisingly steep increase. This 'core' PPI rose 0.4 percent last month, twice the rate economists had expected.

Still, there was evidence of easing price pressures further back in the supply chain. Prices for intermediate goods dropped 1.2 percent, while crude goods prices fell 7.9 percent.

A separate report from the Commerce Department showed business inventories rose a modest 0.3 percent in August as retailers trimmed inventory to cope with consumers cutting back on all but the essentials.

The credit crisis that has raged for some 14 months has taken a heavy toll on consumer confidence and spending.

Excluding autos, retail sales were off 0.6 percent for September, double the 0.3 percent decline that economists had forecast. The housing downturn continued to weigh on sales of furniture and home furnishings, with sales of those items falling 2.3 percent, the sharpest decline since February 2003.

The sales declines were broad, covering everything from auto parts to clothing, department stores to online retailers. Even grocery sales, which had held up long after discretionary spending faded, fell 0.4 percent.

St. Louis Federal Reserve Bank President James Bullard told reporters in Little Rock, Arkansas, that the sales data suggested the economy in the third quarter was likely flat, at best, and could contract. "That is going to push up the probability that it will later be named a recession," he said.

Separately, the New York Fed's "Empire State" index of general business conditions tumbled in October to the lowest since its inception in 2001, hitting minus 24.62, This was below September's minus 7.41 and well under economists' median expectation of minus 10.0.

(Additional reporting by Doug Palmer and Mark Felsenthal in Washington, Alister Bull in Little Rock, Arkansas, and Nick Olivari and Richard Leong in New York; Editing by Jan Paschal)