U.S. producer prices jumped a surprising 1.8 percent last month and industrial output rose firmly, sparking inflation jitters in financial markets.

The data, which came as Federal Reserve officials started a two-day monetary policy meeting, pulled U.S. stocks off 14-month highs and sharply pushed down the price of the inflation-sensitive 30-year government bond on the view that U.S. interest rates could rise sooner than many had expected.

The rise in industrial production, reported by the Fed on Tuesday, was the latest data to suggest the economic recovery is starting to gather some steam. Retail sales also showed strength last month and job losses slowed appreciably.

The market's worried about what's going to make the Fed put the brakes on and what's going to make the Fed put the brakes on is increasing inflation, said Burt White, managing director at LPL Financial in Boston. Everyone's on inflation watch.

U.S. stocks ended down, while prices for government debt dropped. The U.S. dollar climbed to a 2-1/2 month peak against the euro as higher interest rates would raise the yield on dollar-denominated assets.

But many economists said the surge in the Labor Department's producer price index, fueled by a spike in energy costs, did not signal broad inflation pressures given the economy was still hampered by excess capacity.

Fed Chairman Ben Bernanke said the economy had a high degree of slack, which should help to keep inflation contained.

Bernanke's comments came in a letter to a lawmaker on Tuesday.

Analyst had expected the PPI to rise just 0.8 percent after a 0.3 percent gain in October, but a 6.9 percent rise in energy costs helped push it above consensus forecasts.

Prices rose a faster-than-expected 0.5 percent even outside the volatile food and energy sectors, the most in more than a year, but analysts said jumps in prices for light trucks and tobacco that lay behind that gain would not last.


If you look at earlier stages of the production pipeline, (prices) were fairly contained, said Anna Piretti, senior economist at BNP Paribas in New York. I think that the strength of today is unlikely to continue.

For a Reuters graphic on producer prices see http://link.reuters.com/myw86g

In its report, the Fed said U.S. industrial output rose 0.8 percent in November after holding steady in October as manufacturing extended a recent recovery that economists hope will help turn the country's ailing labor market around.

Recent signs of vigor have led many economists to bump up forecasts for fourth-quarter U.S. economic growth. Goldman Sachs joined the growing ranks this week, saying growth would likely come in at a 4 percent annual rate, not the 3 percent pace it had been expecting.

A third report on Tuesday, however, showed a barometer of manufacturing in New York State unexpectedly plummeted in December, indicating the factory sector may have lost a step, while prices paid by manufacturers rose.

For graphics on U.S. manufacturing see http://link.reuters.com/fax86g

The Fed cut benchmark interest rates close to zero a year ago to combat a deepening recession and has vowed to hold them exceptionally low for an extended period. The Fed will issue a statement on Wednesday and markets will eye it closely for any sign policy-makers are backing away from that pledge.

Compared with the same period last year, producer prices were up 2.4 percent in November, posting their first gain in a year and the largest rise since October 2008.

The Fed's report on industrial production showed capacity utilization -- the amount of the nation's industrial capacity being put to use -- rose to 71.3 percent in November from a revised 70.6 in October, its highest since last December but still well below the long-range average.

Low levels of resource utilization and weak demand will determine inflation trends for the next several months, allowing the central bank to hold rates until at least the final quarter of 2010, said Joseph Brusuelas, an economist at Moody's Economy.com in West Chester, Pennsylvania.

The Labor Department will on Wednesday release a report on consumer prices for November. A Reuters survey forecast the Consumer Price Index rising 0.4 percent last month, lifted by higher energy costs, after gaining 0.3 percent in October.

An unexpected drop in home builder sentiment this month could provide the Fed with yet another reason to keep borrowing costs ultra low for a while.

The National Association of Home Builders/Wells Fargo Housing Market Index slipped to 16 from 17 last month, below market expectations for a reading of 18, a survey showed.

(Additional reporting by Pedro Nicolaci da Costa in Washington and Richard Leong, and Leah Schnurr in New York; Editing by Kenneth Barry)