U.S. producer prices rose a steeper-than-expected 0.5 percent last month as food prices jumped, the government said on Tuesday, leading markets to boost bets for another Federal Reserve interest rate hike.

However, the core producer price index, which strips out volatile food and energy costs, rose just 0.2 percent, matching Wall Street forecasts and helping to temper inflation fears.

You are still seeing signs of very strong cost pressures, but the reason for encouragement is that, so far, those higher costs are not being transmitted in any proportional sense to the buyer, said Pierre Ellis, senior economist at Decision Economics in New York.

Economists said that while the June increase in the producer price index was troubling, its significance for Fed policy would pale in comparison with the consumer price index for the month to be released on Wednesday.

In addition, markets were anxiously awaiting testimony on the U.S. economy on Wednesday from Fed Chairman Ben Bernanke.

Prices for U.S. government bonds fell as traders saw the PPI, a gauge of prices received by farms, factories and refineries, increasing chances of an 18th straight interest rate increase when Fed policy-makers meet on August 8.

Traders, however, later trimmed those bets when a survey showed home-builder optimism plummeted to its lowest in more than 14 years.

U.S. stock markets also focused on signs of weaker economic growth, in particular a lower sales forecast from No. 2 U.S. discounter Target Corp. (TGT.N: Quote, Profile, Research). In mid-afternoon, the blue chip Dow Jones industrial average <.DJI> was off about 30 points

In its producer price report, the Labor Department said foods costs shot up 1.4 percent in June, the biggest gain since October 2004. Prices for chickens, eggs and fresh fruits and melons all rose sharply.

Energy costs, which some analysts had expected to hold steady, increased 0.7 percent, partly reflecting a 6.3 percent jump in gasoline prices.

PAYING THE BILLS

During the first six months of the year, producer prices have risen at just a 2.1 percent annual rate, after a 7.5 percent increase in the second half of last year.

The slowdown reflected a moderation in energy price gains. That moderation, however, could prove short-lived if violence continues unabated in the Middle East.

U.S. crude oil prices hit a record high of $78.40 a barrel on Friday, but were trading around $75 a barrel in mid-afternoon on Tuesday.

Rising energy costs present a challenge for the Fed as it tries to contain the inflationary fallout without undue damage to the economy. The U.S. central bank has already lifted the bellwether federal funds rate to 5.25 percent from 1 percent in 17 small steps dating to June 2004.

Prices for U.S. interest rate futures had implied about a 57 percent chance of rate hike next month, but those chances climbed to about 70 percent on the producer price data.

The data on Tuesday underscored the Fed's challenge by combining signs of continued price pressures with indications of slower growth.

The National Association of Home Builders, an industry trade group, said its index of home-builder sentiment dropped 3 points to 39 in July, its lowest since December 1991.

Two other reports showed U.S. chain store sales slowed last week from a week earlier, suggesting warmer-than-normal weather and high gasoline prices deterred shoppers.

A report from the International Council of Shopping Centers and UBS showed a 0.6 percent drop in chain store sales, and only a 2 percent year-on-year gain, the smallest in nearly 1-1/2 years. In its report, Redbook Research said chain store sales last week were up only 2.4 percent from a year earlier.

Separately, the U.S. Treasury Department said net inflows of capital into the United States rose to $69.6 billion in May. Analysts said the increase, which was larger than expected, showed demand for dollar-based assets remained solid.

(Additional reporting by Mark Felsenthal in Washington, and Richard Leong and Torrye Jones in New York)

Ben Bernanke Inflation U.S.