Consumer prices unexpectedly fell in April, the first decline in a year, and the core annual rate recorded its smallest gain since 1966, suggesting scope for the Federal Reserve to keep interest rates near zero for some time.

The Labor Department said on Wednesday its seasonally adjusted Consumer Price Index slipped 0.1 percent, pulled down by a decline in energy costs, after a 0.1 percent gain in March.

Analysts polled by Reuters had forecast consumer prices up 0.1 percent in April. In the 12 months through April, prices increased 2.2 percent.

The latest CPI data confirms that the Fed has a free hand to concentrate on growth and can extend the 'extended period' language, said Alan Raskin, head of currency strategy at RBS Global Banking & Markets in Stamford, Connecticut.

U.S. stock index futures briefly pared losses on the report. Treasury debt prices trimmed losses and the U.S. dollar held at weaker levels against the yen.

Energy costs fell 1.4 percent in April, the largest decline since March 2009. Gasoline costs fell 2.4 percent last month, also the biggest fall since March 2009, after dipping 0.8 percent in March.

The drop in gasoline eclipsed the 0.2 percent gain in food prices.

Excluding volatile energy and food prices, the closely watched core measure of consumer inflation was flat for a second month. Analysts had expected core prices to edge up 0.1 percent.

Substantial slack in the domestic economy, which is pulling out of the longest and deepest recession since the 1930s, is keeping core inflation subdued. Analysts believe this, and the sovereign debt troubles in Europe, should allow the Fed to extend its promise of ultra low interest rates.

Government data on Tuesday showed wholesale prices slipped 0.1 percent in April. Core producer prices, excluding food and energy goods, climbed 0.2 percent from March, but were up just 1 percent compared to April last year.

Last month, core consumer prices were held back by new vehicle and shelter costs which were flat. Apparel fell 0.7 percent, while medical care rose 0.2 percent.

An over supply of homes on the market is keeping renting costs in check.

Compared to April last year, the core inflation rate rose 0.9 percent, the smallest increase since January 1966. Core inflation rose 1.1 percent in the 12 months to March. Analysts had expected core prices to rise 1 percent year-on-year.

Separately, demand for loans to buy homes fell to a 13-year low last week, following the expiration of federal tax credits, while near-record low mortgage rates stoked refinancing, the Mortgage Bankers Association said.

Mortgage purchase applications sank 27.1 percent to the lowest level since May 1997 in the absence of the popular government support, the group said. Requests for home purchase loans have fallen almost 20 percent over the past month despite low borrowing costs.

(Reporting by Lucia Mutikani; Editing by Neil Stempleman)

Inflation