By Lucia Mutikani WASHINGTON (Reuters) - U.S. retail sales were unexpectedly flat in July as Americans cut back on discretionary spending, pointing to a moderation in consumption that could temper expectations of a sharp pickup in economic growth in the third quarter. Other data on Friday showed that producer prices recorded their biggest drop in nearly a year in July amid declining costs for services and energy goods. Cooling consumer spending and tame inflation suggest the Federal Reserve will probably not raise interest rates anytime soon despite a robust labor market. "Fed members are afraid to come out from under their rocks until growth is sustainably solid and inflation in, near or at their target, and today's reports don't provide them with any comfort that will happen soon," said Joel Naroff, chief economist at Naroff Economic Advisors in Holland, Pennsylvania. July's unchanged retail sales reading followed an upwardly revised 0.8 percent increase in June, the Commerce Department said. Retail sales in June were previously reported to have increased 0.6 percent. Sales rose 2.3 percent from a year ago. Motor vehicle sales increased 1.1 percent last month. Rising demand for autos is pulling spending away from discretionary items, including sporting goods, whose sales in July suffered their biggest drop since January 2015. Excluding automobiles, gasoline, building materials and food services, retail sales were also unchanged last month after rising 0.5 percent in June. These so-called core retail sales correspond most closely with the consumer spending component of gross domestic product. Economists had forecast overall retail sales rising 0.4 percent and core sales climbing 0.3 percent last month. Some cautioned against reading too much into the July data, citing a labor market that is at or near full employment, and said they expected sales to bounce back in August. "You have had two months of very strong job growth. It just seems very odd that spending would be weak. I will wait for the revisions before declaring July retail spending means anything more than random volatility," said Steve Blitz, chief economist at M Science in New York. U.S. Treasuries were trading higher on the data, while the dollar <.DXY> fell against a basket of currencies. U.S. stocks were little changed as the impact of rising oil prices offset the weak data. There was another jump in online sales last month as they continued to grab market share from traditional retailers. Macy's said on Thursday it would close an additional 100 stores as it tries to turn around its business after six quarters of falling sales. Like other department stores, Macy's has been squeezed by stiff competition from online retailers such as Amazon.com . "The growth of on-line retailing is having impacts on the broader economy. For one, construction of shopping centers and other commercial structures obviously has suffered," said Michael Feroli, an economist at JPMorgan in New York. "Thankfully, commercial building has never been a huge share of business construction spending and so the impact on GDP is rather limited." PRICE PRESSURES MUTED Separately, the Labor Department said its producer price index for final demand dropped 0.4 percent last month, the first decline since March and the largest since September 2015. It increased 0.5 percent in June. In the 12 months through July, the PPI slipped 0.2 percent. That was the biggest drop since December 2015 and followed a 0.3 percent increase in the 12 months through June. A strong dollar and cheaper oil continue to keep price pressures muted, leaving inflation running persistently below the Fed's 2 percent target. Fed officials have repeatedly expressed concern about low inflation. The U.S. central bank raised its benchmark overnight interest rate last December for the first time in nearly a decade. Although a Reuters poll on Thursday found that most economists expect another rate increase in December, financial markets currently anticipate such a move only next year. Interest rate futures after Friday's data placed only a 43 percent probability of a December rate hike, compared to 47 percent before the data. Robust consumer spending has helped to cushion the blow on the economy from an inventory correction and the prolonged drag from lower oil prices that have restricted GDP growth to an average 1.0 percent annualized rate in the last three quarters. While Friday's data suggested consumer spending was cooling after the second quarter's brisk 4.2 percent rate of increase, economists still expected growth in consumption to top a 2.5 percent pace in the current quarter. Strong labor market gains as well as rising home and stock market prices should underpin spending. The economy created a total of 547,000 jobs in June and July. A third report showed consumer sentiment was stable in early August, though households' views on income softened a bit. Most of the weakness was among younger households who cited higher expenses than anticipated, according to the University of Michigan's preliminary consumer sentiment survey. Americans are facing rising rents and healthcare costs. Following the retail sales report, the Atlanta Fed lowered its third-quarter GDP growth estimate by two-tenths of a percentage point to a 3.5 percent rate. Growth is expected to be driven by a rebound in inventory investment, as well as consumer spending. A fourth report from the Commerce Department showed businesses made significant progress in June in their efforts to reduce an inventory overhang that has weighed on economic growth since the second quarter of 2015. The inventory-to-sales ratio fell to a seven-month low of 1.39 months in June. (Reporting by Lucia Mutikani; Additional reporting by Nandita Bose in Chicago; Editing by Chizu Nomiyama and Paul Simao)
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