By Joanne Morrison

WASHINGTON - Wholesale prices fell unexpectedly in July, leaving little worry of inflation and giving the Federal Reserve ample time to keep interest rates at 40-year lows while the economy staggers to recovery.

In addition, the labor market is showing signs of slow improvement in the face of growing economic uncertainty. But sales at discount stores -- the kingpin of consumer spending during the slowdown -- came in lower than expected, latest data on Thursday showed.

The Labor Department's Producer Price Index, a closely watched gauge of inflation at the wholesale level, declined by 0.2 percent, defying Wall Street economists' expectations of a slight 0.1 percent gain.

The department said excluding declines in prices for both cars and light trucks that were brought on by zero percent financing deals and other producer incentives, the overall wholesale inflation index would have been unchanged.

Economists agreed the PPI report confirms that inflation is indeed not a threat. And most of Wall Street believes the Fed is not likely to cut interest rates any time soon, even with a weakening economic picture.

Policymakers will meet Tuesday to set interest rates.

"The latest PPI figures strengthen the case for holding interest rates steady but do not even come close to making a case for cutting them," said Mark Vitner, senior economist at Wachovia Securities in Charlotte, N.C.

The core PPI rate, which excludes volatile food and energy prices, fell by 0.3 percent. It was the biggest drop in nine months and also was unexpected.

On the labor front, a government report showed that fewer Americans last week signed up for jobless benefits. The four-week moving average of these claims, a less volatile figure, dropped to its lowest level in more than a year.

"The weekly claims data continue to point to gradual labor market improvement, however payroll growth remains very sluggish,' said Susan Polatz, economist at Banc of America Securities in New York.

In a sign companies are slow to take on new hires, the number of workers remaining on jobless benefits remained at levels seen after the Sept. 11 attacks when the economy began hemorrhaging jobs, according to the Labor Department report.

RETAILERS SEE ONLY MODEST GAINS

Consumer spending has slowed, according to same-store sales reports out on Thursday. The nation's key retailers reported only modest gains, at best, in July as consumers pulled back on spending in the face of the prolonged stock market slump.

Among those stores, the world's No. 1 retailer, Wal-Mart Stores Inc., said its July sales came in lower than expected.

For most retailers, tighter control over inventories led to fewer clearance sales and better profit margins in July. But that also made for less overall merchandise sold.

Higher priced department stores reported declines, as consumers leery about the economy opted for discounters.

"July sales are soft and we relate this to the fact that there is very little hiring going on," said Kurt Barnard, publisher of Barnard's Retail Trend Report. "People will buy what they need, not what they want."

Stocks continued their third session in positive territory. At midday the Dow Jones Industrial Average was up more than 80 points and the tech-laden Nasdaq Composite Index added more than 4 points.

U.S. treasury bonds were down as investors turned to improving stock markets.

FED MEETS NEXT WEEK

Amid growing signs of economic weakness, the benign reading on wholesale inflation during July will no doubt give the Fed room to hold its benchmark overnight interest rate at a 40-year low of 1.75 percent for a prolonged period.

Fed officials will meet to consider interest-rate policy on Tuesday amid widespread expectations they will not make any interest-rate move.

But a spate of weak economic data has driven a handful of Wall Street firms who trade directly with the Fed to predict the central bank may opt to reduce rates even more this year. Among 21 of these primary dealers, four expect more cuts by year-end, according to a recent Reuters poll.

That sentiment has helped drive down the average 30-year fixed-rate mortgage this week to new lows not seen in decades, according to mortgage finance giant Freddie Mac.

"That expectation, in turn, has created a boon for potential and existing homeowners in the form of lower mortgage rates," said Frank Nothaft, Freddie Mac's chief economist.

Last year as the economy sank into recession, the Fed cut interest rates 11 times. But so far this year, it has kept rates unchanged.