* Core producer prices fall 0.6 pct in October on autos
* Decline in core PPI largest since July 2006
* Headline PPI index rises 0.4 pct, below forecasts
* Industrial output flat in October; utilities drag (Updates markets to close)
By Lucia Mutikani
WASHINGTON, Nov 16 (Reuters) - Core U.S. producer prices recorded their largest fall in more than four years in October and industrial output was flat, underlining concerns at the Federal Reserve about low inflation amid moderate growth.
Economists said the data supported the U.S. central bank's Nov. 3 decision to ease monetary policy further even though the 0.6 percent drop in the core Producer Price Index largely reflected the annual introduction of new motor vehicle models.
Stripping out the sharp declines in vehicle prices, core producer prices -- which exclude volatile food and energy costs -- would have risen by 0.2 percent, the Labor Department said on Tuesday, a modest gain consistent with the economy's sluggish growth trend and tepid domestic demand.
"Today's PPI data shows you that beneath the surface there is not a whole lot of inflation and tomorrow's (consumer price) data is likely to show the same thing," said John Canally, a economist at LPL Financial in Boston.
"The Fed is not going to be proven right with one month of inflation data, but you just need to look around where wage costs are. The PPI data supports what the Fed is doing."
The overall decline in the core index was the biggest since July 2006 and followed a 0.1 percent gain in September. A similar increased had been expected in October.
Graphic on producer prices: r.reuters.com/caw65q
The weak inflation report ignited a rally on the U.S. government debt market, where the the 30-year bond posted its biggest one-day gain. Ongoing concerns over Ireland's debt crisis and tight credit in China eroded risk appetite.
U.S. stock indices ended down more than 1.5 percent, while the dollar scaled a seven-week high against the euro.
Concerns that low inflation could spiral into a damaging phase of deflation prompted the U.S. central bank this month to ease monetary policy further, a step that will see it buy $600 billion worth of government bonds through the middle of 2011.
That measure has been criticized by some economists, amid signs that the recovery from the worst economic downturn since the 1930s is regaining some strength after losing momentum in the summer.
Despite brighter signs, soft demand is forcing retailers to continue with price discounting to lure customers.
Wal-Mart Stores Inc (WMT.N), the world's largest retailer, said on Tuesday there were indications consumers were still shopping paycheck-to-paycheck. Still, cost cutting helped it to a higher quarterly profit. [ID:nN1691422]
Home improvement chain Home Depot Inc (HD.N) also reported earnings that beat expectations, but it softened its full-year sales forecast [ID:nN1627318].
A separate report from the Fed showed industrial production was flat last month, short of economists' expectations for a rise of 0.3 percent, largely because of weak utility output that reflected unusually warm weather. But manufacturing production rose 0.5 percent, its biggest gain since July.
"The rise in manufacturing is consistent with other reports out there showing the economy picked up strength at the start of the fourth quarter," said Jim O'Sullivan, chief economist at MF Global in New York.
Economists do not expect the distortions from the annual introduction of new vehicle models to spill over into data on consumer inflation, which is due on Wednesday. Core consumer prices are expected to have edged up 0.1 percent after being flat in September.
The core PPI was depressed by a 4.3 percent drop in the price of light motor trucks and a 3 percent drop in prices for passenger cars. In the 12 months to October, core prices have risen just 1.5 percent.
While core prices fell sharply, overall prices received by U.S. farms, factories and refineries rose 0.4 percent, but that was well below economists' expectations for a 0.8 percent gain. Wholesale prices increased 0.4 percent in September.
Though upward pressure from rising commodity prices is starting to show, economists said it was unlikely to feed through to consumer prices in a meaningful way.
"It is not true to say that no cost increases are filtering through, but there's still so much excess capacity in the economy that core inflation will remain quiet despite higher costs," said Nigel Gault, chief U.S. economist at IHS Global Insight in Lexington, Massachusetts. (Additional reporting by Emily Kaiser in Washington; Editing by Andrea Ricci)