* U.S. factory output shrinks in April * New York state manufacturing activity contracts in May * Producer prices fall 0.7 percent in April * Wholesale price drop largest in three years By Lucia Mutikani WASHINGTON, May 15 (Reuters) - U.S. factory output dropped in April and manufacturing activity in New York state contracted this month, a sign that slowing global demand is weighing on the economy. The anemic growth picture was highlighted by another report on Wednesday showing the largest decline in wholesale prices in three years. The data gives the Federal Reserve latitude to keep priming the economy with an easy monetary policy. "The somewhat sluggish economic growth and limited inflation are the equivalent of rocket fuel for the Fed," said Joel Naroff, chief economist at Naroff Economic Advisors in Holland, Pennsylvania. U.S. Treasury debt prices rose on the reports and the dollar retreated from 4-1/2 year highs against the yen as investors fine-tuned their bets on Fed policy. Stocks on Wall Street trended higher while gold prices fell to their lowest in nearly a month. Manufacturing production fell 0.4 percent last month after declining 0.3 percent in March, the Fed said. That pushed overall industrial output down by 0.5 percent, more than unwinding March's 0.3 percent advance. Economists had expected industrial output to fall only 0.2 percent last month. The drop in factory output, which accounts for more than 70 percent of industrial production, was broad-based and in keeping with data earlier this month that showed factory payrolls failed to expand last month. Industrial capacity utilization, a measure of how fully the nation's mines, factories and utilities are deploying their resources, dropped sharply from a more than 4-1/2 year high. A recession in the euro zone and slower growth in China has undercut demand for U.S. exports, taking some steam out of the factory sector. A strengthening in the dollar against both the euro and the yen has also hurt. At the same time, manufacturing has been hit hard by belt-tightening in Washington, in particular $85 billion in across the board spending cuts that kicked in on March 1. Other areas of the economy such as employment, housing and the retail sector have shown surprising resilience, which should limit the degree to which the economy slows. Manufacturing accounts for about 12 percent of U.S. GDP. "Manufacturing is struggling. The weakness in Europe's economy and softening emerging markets is hurting U.S. manufacturers more than the domestic economy," said Ryan Sweet, a senior economist at Moody's Analytics in West Chester Pennsylvania. "That's going to linger for sometime." Indeed, a second report showed manufacturing activity in New York state fell in May as new orders, unfilled orders and shipments of finished goods all declined. The New York Federal Reserve's "Empire State" general business conditions index fell to minus 1.43 this month from 3.05 in April. A reading below zero indicates a contraction in the region's factories. INFLATION MUTED Economists said the weakness in manufacturing, one of the main drivers of growth since the 2007-09 recession ended, suggested the economy could slow to a 2 percent annual growth pace in the second quarter. It expanded at a 2.5 percent rate in the first three months of the year. With domestic demand lackluster, the euro zone economy mired in a recession and growth in China slowing, disinflation is creeping into the U.S. economy. The Labor Department said its producer price index fell 0.7 percent last month, the biggest decline since February 2010. Wholesale prices had dropped 0.6 percent in March. In the 12 months through April, wholesale prices were up only 0.6 percent, the smallest increase since July last year. Prices had increased 1.1 percent in March. Underscoring the tame inflation environment, core wholesale prices, which strip out volatile food and energy costs, nudged up just 0.1 percent, the smallest gain since November. With little sign of pipeline price pressures, consumer inflation should remain low this year, providing scope for the Fed to maintain its monthly $85 billion purchases of mortgage and Treasury bonds to keep rates low and speed up job growth. "Inflation is too low, but not low enough to really get the Fed to increase the size of its asset purchases," said Sweet. A measure of consumer inflation closely watched by the Fed has slowed sharply since the start of the year. It now stands a full percentage point below the Fed's 2 percent target. A core measure is nearly as low. Data on Thursday is expected to show the downward trend in consumer prices persisted in April. Last month, wholesale gasoline prices fell 6.0 percent after dropping 6.8 percent in March. That led energy prices down by 2.5 percent in April, a decline that accounted for more than 80 percent of the overall drop in wholesale prices. Producer prices were also dampened by a 0.8 percent decline in food prices, the largest fall since May 2011. Food prices were held down by a collapse in the wholesales prices of strawberries, eggs and fresh and dry vegetables.