(Updates with market close)
By Glenn Somerville and Lisa Lambert
WASHINGTON, Aug 19 (Reuters) - U.S. wholesale prices shot up in July at the fastest annual rate in 27 years, while home builders cut back on construction as they worked through a glut of unsold homes, government data showed on Tuesday.
The reports offered little solace to the Federal Reserve, which is hoping a slowing economy will cool inflation so the central bank can hold off raising interest rates.
"Two consecutive elevated readings on core consumer prices, combined with today's worrisome report on producer prices, will be hard for the Fed to overlook at its next meeting," said Kenneth Beauchemin, U.S. economist with Global Insight in Lexington, Massachusetts.
"That said, recent and further evidence of significant economic weakness makes it unlikely for the Fed to push up interest rates this year," he added.
The Fed's policy-setting committee is to next meet on Sept. 16.
The Labor Department's Producer Price Index, which measures prices at the factory door, climbed 1.2 percent in July over the prior month, after a 1.8 percent gain in June. So-called core producer prices, which exclude food and energy, jumped 0.7 percent in July after a 0.2 percent June increase.
Economists polled by Reuters had expected producer prices to rise just 0.6 percent in July, and had forecast that core prices would be up only 0.2 percent. The rise in monthly core producer prices was the strongest since November 2006 and implied that price gains were spreading outside the food and energy sectors.
On a year-over-year basis, the index rose 9.8 percent, the biggest jump since June 1981.
A sharp decline in oil prices since mid-July has led many investors to conclude that inflation pressures were subsiding, and many economists said the July report would likely be the worst for a while.
The steep jump in core prices rattled U.S. financial markets, helping drive stock indexes down more than 1 percent. U.S. Treasury debt prices initially rose as investors looked for a safe haven from falling stocks, but ended mixed.
"There's nothing good about it," said Marc Pado, U.S. market strategist at Cantor Fitzgerald & Co in San Francisco. "Inflation is more systemic than they were leading us to believe in the past numbers and it will continue to show up in the CPI number for months to come. The question is whether or not investors can shake it off knowing that the price of oil has come down.
"The Fed is stuck between a rock and a hard place, and it shows," he added.
Separately, the Commerce Department reported that U.S. home building projects started in July fell 11 percent to the lowest annual rate in more than 17 years, while building permits tumbled 17.7 percent.
The annual pace of housing starts, at 965,000, was slightly above Wall Street's expectations of 960,000. But it was the lowest level since a 921,000 unit rate in March 1991. In June, housing starts rose 10.4 percent, revised up from the previously reported 9.1 percent gain.
"The U.S. economy is growing and showing great flexibility, but we're in a period of slow growth," White House spokesman Tony Fratto said. "When the housing sector returns we expect broader economic activity to return as well."
Building permits, an indicator of future construction, dropped to an annual rate of 937,000, well below the 970,000 analysts polled by Reuters had forecast. It was the lowest level since March, when they were 932,000, the Commerce Department said.
Single family homes, which constitute the bulk of new housing, were especially weak. The annual unit rate of 641,000 single family homes started in July was the lowest since January 1991, when they were 604,000. Building permits were 584,000, the lowest since 523,000 in August 1982. (Additional reporting by Herb Lash in New York and Tabassum Zakaria in Washington; Editing by Leslie Adler)