By Emily Kaiser

A wholesale inflation index eased, suggesting the Federal Reserve has room to lower benchmark interest rates further to try to prop up an increasingly shaky U.S. economy.

Retail sales fell 1.2 percent in September to a seasonally adjusted $375.5 billion, the Commerce Department said on Wednesday. It was the sharpest drop since August 2005 and far greater than the 0.7 percent decline economists had expected.

"We have an all-out consumer retrenchment under way," said National City Corp chief economist Richard DeKaser in Cleveland, adding he expected the economy to shrink in coming months.

The Labor Department said the producer price index, a gauge of prices received by farms, factories and refineries, dropped 0.4 percent in September, in line with expectations, as a further fall in energy costs eased price pressures.

With the economy on weak ground and inflation cooling, investors bet on further interest rate reductions from the Fed -- the U.S. central bank -- on top of the 3.75 percentage points in cuts it has already made in the past 13 months.

The blue chip Dow Jones industrial average and the broad Standard and Poor's 500 Index dropped by more than 3 percent in early trading after the unexpectedly steep fall in retail sales and weak factory data, while U.S. government debt prices rose on rate cut expectations.

"The question on everyone's minds is how deep of a recession (will there be)," said Kathy Lien, director of currency research at GFT Forex in New York.

"Today's (retail sales) number indicates a very strong chance of negative GDP growth for the third quarter and would certainly pave the way for another 25 to 50 basis points of easing (of monetary policy) over the next few months, and the PPI number confirms that as inflation is coming down as well," she said, referring to U.S. gross domestic product.

There are 100 basis points in a percentage point.

INFLATION PIPELINE

Falling oil prices cooled overall inflation, but a closely watched measure of prices that strips out food and energy costs posted a surprisingly steep increase. This 'core' PPI rose 0.4 percent last month, twice the rate economists had expected.

Still, there was evidence that price pressures were easing throughout the supply chain, which should lead to lower inflation. Prices for intermediate goods dropped 1.2 percent, while crude goods prices fell a sharp 7.9 percent.

A separate report from the Commerce Department showed business inventories rose a modest 0.3 percent in August, less than the 0.5 percent expected. Retailers trimmed inventory to cope with consumers cutting back on all but the essentials.

The credit crisis that has raged for some 14 months has taken a heavy toll on consumer confidence and spending.

Excluding autos, retail sales were off 0.6 percent for September, double the 0.3 percent decline that economists had forecast. The house downturn continued to take a toll on furniture and home furnishings, with sales of those items falling 2.3 percent, the sharpest decline since February 2003.

The sales declines were broad, covering everything from auto parts to clothing, department stores to online retailers. Even grocery sales, which had held up long after discretionary spending faded, fell 0.4 percent.

Separately, the New York Fed's "Empire State" index of general business conditions tumbled in October to the lowest since its inception in 2001, hitting minus 24.62, This was below September's minus 7.41 and well under economists' median expectation of minus 10.0.

(Additional reporting by Doug Palmer in Washington and Nick Olivari and Richard Leong in New York; Editing by James Dalgleish)