Producer prices in February posted their biggest fall in seven months as energy costs tumbled, validating the Federal Reserve's decision to hold interest rates very low on evidence of tame inflation.

The Labor Department on Wednesday said its Producer Price Index, which measures prices paid at the farm and factory gate, fell 0.6 percent after rising 1.4 percent in January.

Even excluding volatile energy and food costs, core producer prices rose just 0.1 percent last month.

The inflation picture is pretty benign, said Nick Kalivas vice president of financial research at MF Global in Chicago, adding that the Fed would likely only raise its benchmark interest rate late this year or in early 2011.

The drop in wholesales prices exceeded market expectations for a 0.2 percent fall.

The report came a day after the U.S. central bank renewed its promise to hold benchmark interest rates exceptionally low for an extended period, arguing that substantial resource slack would likely keep inflation subdued for some time. It left overnight rates in a range of zero to 0.25 percent.

Stocks rose on the tame inflation report and the Fed's commitment to low borrowing costs. Prices for long-dated U.S. government rose modestly, while the dollar gained against the euro.

Compared to February last year, producer prices increased 4.4 percent, but they slowed from a 4.6 percent year-on-year rise in January and were below market expectations for a 4.9 percent increase.

TREMENDOUS SLACK

With the unemployment at 9.7 percent and likely to remain elevated for some time, inflation pressures will probably stay muted even if the pace of the economic recovery picks up.

There is still a lot of tremendous slack in the economy, both in the labor market and in terms overall industrial capacity, said Joseph Brusuelas, chief economist at Brusuelas Analytics in Stamford, Connecticut.

Moreover, firms do not have pricing power even though we see price increases at earlier stages of production. Firms are using their increasing profit margins to absorb the rise in those costs and are not passing them downstream to customers.

The Labor Department attributed the February fall in wholesale prices to a 2.9 percent drop in energy costs, which was also the largest decline in seven months and represented a sharp reversal from January, when energy costs surged 5.1 percent.

Gasoline prices plummeted 7.4 percent after an 11.5 percent rise in January. Food prices rose 0.4 percent after rising by the same margin in January.

However, oil prices have been creeping higher in recent weeks, climbing to more than $82 per barrel on Wednesday. The price dipped below $70 a barrel as recently as February 5. Analysts still don't see a threat to inflation from rising oil prices.

Core producer prices, which exclude energy and food costs, edged up 0.1 percent last month, slowing from January's 0.3 percent increase. The rise in the core index was in line with expectations.

Core prices last month were lifted by a 0.5 percent rise in the index for passenger cars. It was the largest increase since June. The core producer price index rose 1.0 percent measured on a year-on-year basis, also in line with expectations and following a similar rise in January.

The sharp drop in unit labor costs in manufacturing means we still expect core PPI to drop below zero on a year-on-year basis before rebounding later in second half, said Ian Shepherdson, chief U.S. economist at High Frequency Economics in Valhalla, New York.

The Labor Department on Thursday will report on consumer prices for February, which are expected to show a similar pattern of tame inflation. Economists polled by Reuters expect the Consumer Price Index to rise 0.1 percent rise. The forecast is for a similar increase for CPI excluding food and energy.

Separately, applications for home loans fell last week despite the lowest mortgage rates in more than three months, the Mortgage Bankers Association said.

The industry group's market index, which includes purchase and refinance applications, dropped 1.9 percent to a three-week low despite improving borrowing costs. Average 30-year mortgage rates slipped 0.10 percentage point to 4.91 percent.

(Additional reporting by Lynn Adler in New York; Editing by Kenneth Barry)

Inflation