Jan. 15 (Bloomberg) -- Prices paid to U.S. producers unexpectedly fell in December as inflation pressures receded at the end of a year that saw the biggest increase in more than a quarter-century.

A temporary drop in energy costs pulled prices at the producer level down 0.1 percent in December following a 3.2 percent November surge that was the biggest in 34 years, the Labor Department reported today in Washington. For all of 2007, inflation at the wholesale level climbed 6.3 percent, the most since 1981.

Outside of food and energy, prices increased just 2 percent last year, indicating that slowing economic growth is making it difficult for businesses to pass higher costs along. That's helping to keep inflation in check as Federal Reserve policy makers cut interest rates to try to prevent a recession.

``In the end, the Fed is going to put their inflation concerns on the back burner and focus on what they perceive as a more pressing problem, the weakness in the economy,'' said Michelle Girard, an economist at RBS Greenwich Capital in Greenwich, Connecticut. ``Looking beyond this year to 2009, when we think growth will be back above its long-term potential, the Fed could find itself with more of an inflation problem.''

1981 Inflation

The last time wholesale prices rose faster, during the first year of Ronald Reagan's presidency in 1981, the U.S. was in the middle of its second recession in two years. Inflation had infected the economy at all levels, with consumer prices rising at a rate of 10 percent or more for most of the prior three years. That year the Fed pushed its target interest rate to a record 20 percent to wring inflation out of the economy.

December's drop in producer process compares with a 0.2 percent increase forecast in a Bloomberg News survey of 73 economists. Estimates ranged from a decline of 1 percent to a gain of 0.9 percent.

Excluding food and energy, so-called core prices rose 0.2 percent, matching estimates, after increasing 0.4 percent the prior month.

A separate report from the Commerce Department today showed retail sales unexpectedly fell 0.4 percent in December. Purchases excluding automobiles also declined 0.4 percent.

CPI Report

The producer price index is the second of three monthly reports on inflation for December. Prices of goods imported into the U.S. were unchanged last month, held down by a drop in petroleum costs, after soaring the most in more than 17 years in November.

The government is scheduled to release the consumer price index tomorrow.

Rising prices have complicated matters for Fed policy makers as they lower interest rates to keep economic growth from stalling.

``I am troubled by the elevated level of inflation,'' Fed Bank of Atlanta President Dennis Lockhart said Jan. 7, adding that his forecast of moderate price gains may be ``too optimistic.''

Even so, ``entrenched'' inflation expectations give the Fed some flexibility, according to Fed Bank of St. Louis President William Poole.

Fed Meeting

The Fed is scheduled to vote on interest rate policy on Jan. 30. Traders increased bets the central bank will cut its overnight lending rate between banks by half a percentage point, to 3.75 percent, after Chairman Ben S. Bernanke said last week that ``we stand ready to take substantive additional action'' to insure against ``downside risks'' to the economic expansion.

Energy costs fell 1.9 percent after rising 14 percent in November. Prices of gasoline fell 4.8 percent and diesel fuel costs dropped 3 percent.

The timing of the survey may account for the declines in energy costs. Prices of crude oil gained in the latter half of December after the survey was completed.

The price of crude oil futures traded on the New York Mercantile Exchange averaged $91.74 a barrel in December and have since climbed, reaching a record $100.09 a barrel Jan. 3.

Food prices rose 1.3 percent, led by fresh fruit and vegetable costs. Crude food prices, which cover costs of corn and wheat, rose 4.3 percent.

General Mills Inc., the second-largest U.S. cereal maker, has raised prices on Yoplait yogurt, Pillsbury refrigerated dough and other products to blunt the effect of higher wheat and dairy costs, Chief Financial Officer Don Mulligan said Jan. 11 at a New York conference. The price increases became effective Nov. 1 and follow other adjustments made earlier in the year.

Crude Goods

Producer prices for all crude goods rose 1 percent in December, after an 8.7 percent gain a month earlier. Excluding food and energy costs, prices for raw materials were unchanged. Costs of intermediate goods, such as steel used in earlier stages of production, fell 0.2 percent in December after a 3.7 percent increase in November. They rose 6.8 percent last year.

Excluding food and energy, intermediate prices were unchanged in December.

The cost of consumer goods fell 0.1 percent, following a 4 percent increase in November. Prices for capital goods rose 0.1 percent.

Some companies are changing strategy to try to address higher costs and anticipation of slower consumer spending.

Southwest Airlines Co., acting on concern about higher fuel prices and slower economic growth, said Jan. 9 it will cut 57 round-trip flights from its schedule while adding service in higher-demand areas such as Denver.

``The bookings for January don't suggest anything to be alarmed about,'' Southwest Chief Executive Officer Gary Kelly said in an interview. ``There are plenty of signs out there that point to the potential for weakness this year. Given $100 crude oil, we don't want to be wrong.''

To contact the reporter on this story: Courtney Schlisserman in Washington cschlisserma@bloomberg.net.

Last Updated: January 15, 2008 11:22 EST