Consumer prices fell slightly more than expected in June to post their biggest drop in a year on weak gasoline costs, but underlying inflation pressures remain elevated.

The Consumer Price Index fell 0.2 percent, the Labor Department said on Friday, the largest drop since June 2010, after rising 0.2 percent in May. Economists had expected prices to fall 0.1 percent.

But stripping out food and energy, core CPI rose 0.3 percent after a similar gain in May and above economists' expectations for a 0.2 percent increase.

We are getting a very, very sharp rebound in core inflation and much more than the Fed had bargained for. We will be at price stability and possibly through it before the end of this year, said Eric Green, chief economist at TD Securities in New York.

Separate reports showed manufacturing is weak. Factory output was flat nationally in June while a gauge of manufacturing in New York state fell again in July.

What a dilemma, slow growth and higher core inflation, said David Ader, head of government bond strategy at CRT Capital Group in Stamford, Connecticut.

Industrial production rose in June for the first time in three months after revisions, on a jump in utilities and mining output, a Fed study showed. Manufacturing posted its weakest rise in the second quarter since the recession ended mid-2009, the Fed said.

The New York Federal Reserve said its Empire State general business conditions index was at minus 3.76 from minus 7.79 in June.

It's still a disappointing sign that manufacturing sectors hit a bit of a stall but it's not conclusive, David Resler, chief U.S. economist for Nomura Securities, New York.

U.S. stocks pared gains and the dollar edged higher against the euro after the consumer price data.

High inflation, driven by strong energy and food prices, undermined economic activity in first quarter, with growth slowing sharply to a 1.9 percent annual rate after a brisk 3.1 percent expansion in the final three months of 2010.

The economy is believed to have grown by between 1.5 percent and 2.0 percent in the second quarter.

Hopes of a stronger pick-up in growth during the July-September period have been dented somewhat by a weak labor market and retail sales in June.

But abating commodity inflation pressures as energy prices decline, should put more money in the pockets of consumers who have been stretching to cover rising costs for gasoline and food.

Federal Reserve Chairman Ben Bernanke said this week the U.S. central bank was prepared to act if growth falters further, but made it clear that Fed is not at that point yet.

Bernanke noted that inflation was higher than in late 2010, when the Fed got ready for its $600 billion government bond- buying program, which ended in June.

GASOLINE PRICES FALL

Gasoline prices dropped 6.8 percent, the largest decline since December 2008, after falling 2.0 percent in May. Food prices rose a moderate 0.2 percent after increasing 0.4 percent in May.

But rising costs for housing, new vehicles, used trucks and apparel pushed up core inflation last month. Shelter costs rose 0.2 percent for a second straight month, while apparel prices jumped 1.4 percent, the largest increase since March 1990.

Prices for new vehicles increased 0.6 percent last month, slowing from May's 1.1 percent surge, likely reflecting an easing of auto shortages related to supply chain disruptions from Japan. Used cars and trucks jumped 1.6 percent, the largest increase since December 2009.

In the 12 months to April, core CPI rose 1.6 percent after increasing 1.5 percent in May. Fed officials, however, would like to see that closer to 2 percent.

Overall consumer prices were up 3.6 percent from a year earlier, after rising 3.6 percent in May.

(Reporting by Lucia Mutikani; Editing by Neil Stempleman)

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