NEW YORK (Reuters) - Weak U.S. retail sales and a rise in producer prices to their highest annual rate in 27 years provided further evidence of “stagflation” in the world’s largest economy on Tuesday.

Chevrolet Uplander minivans are seen at a dealership in Silver Spring, Maryland, July 1, 2008. REUTERS/Yuri Gripas

Federal Reserve Chairman Ben Bernanke reinforced the troubled outlook, saying the economy faced significant downside risks, even though the Fed -- the U.S. central bank -- raised its forecast for growth as well as for inflation this year.

U.S. retail sales rose a less-than-expected 0.1 percent in June, as auto sales posted their biggest drop in more than two years, government data showed, leading investors to lower bets that the Fed would raise benchmark interest rates this year.

Also on Tuesday, General Motors Corp said it would cut labor costs, sell assets and borrow at least $2 billion to bolster finances in the face of plummeting sales.

The U.S. Labor Department said producer prices over the last 12 months jumped 9.2 percent, the biggest increase since a 10.4 percent gain in June 1981 when the United States was last mired in a stagflationary period of low growth and high inflation.

“The PPI number is just outrageous,” said T.J. Marta, fixed-income strategist at RBC Capital Markets in New York.

On Wall Street, U.S. stocks fell on persistent worries about the health of the financial system, while oil prices dropped on concerns about the U.S. economy.

The U.S. dollar fell against a broad basket of currencies but managed to recover from a record low against the euro seen overnight.

U.S. government bonds, which generally benefit in times of economic weakness, rose as investors pared their bets on the possibility of Fed interest rate hikes this year.

The Fed’s rosier growth projection gave cold comfort to investors hit by the recent downturn in the stock market and consumers facing soaring energy prices and higher joblessness.

Economists shrugged off the Fed’s forecast and focused on Bernanke’s assessment of the economy, which is struggling with a deep housing downturn, financial markets turmoil and a high degree of uncertainty over inflation and growth.

“SIGNIFICANT” RISKS

In remarks to the U.S. Senate Banking Committee, Bernanke focused on stress in financial markets.

He also said the possibility of higher energy prices, tighter credit and a deeper contraction in housing markets were “significant downside risks” to the growth outlook.

He also said the risks of higher inflation had intensified on the back of rising prices of energy and other commodities, but analysts zeroed in on the weak growth prospects.

“There seems to be more emphasis on the concerns for the economy rather than on inflation,” said Kevin Flanagan, fixed income strategist for global wealth management with Morgan Stanley in Purchase, New York.

“These are all signs the Fed has no room to raise rates any time over the near term.”

The Fed raised its projection for growth in 2008 to a range of 1.0 to 1.6 percent from a 0.3 to 1.2 percent range seen in April, on expectations for stronger consumer spending.

San Francisco Fed President Janet Yellen said the intense wave of U.S. home foreclosures risked triggering a cycle of decline in some communities, and the Fed viewed this as an urgent problem.

U.S. President George W. Bush said the economy was expanding but “not growing the way it should.”

“I’m not an economist, but I do believe that we’re growing,” Bush said at a news conference.

A regional manufacturing survey showed factory activity in New York contracted for the fifth time in six months and data in the report suggested producers were passing on higher prices to consumers, which could add further fuel to inflation.

CHECKS ALREADY CASHED

Economists had expected government tax rebate checks to boost June retail sales more, despite the weak economy, but much of that seems to have been reflected in May’s gains.

Economists polled by Reuters had forecast total retail sales to rise 0.4 percent in June after a 0.8 percent gain in May that was initially reported as a 1.0 percent rise.

Excluding autos, retail sales rose 0.8 percent, also below the pre-report consensus of 1.0 percent. Excluding autos, building supplies and gasoline, retail sales rose 0.4 percent.

U.S. producer prices rose a far larger-than-expected 1.8 percent on the month in June as energy costs soared. If there was any good news, it was that core prices at the producer level, excluding food and energy, edged up just 0.2 percent.