Adds Trump comments in paragraph 4, updates markets in paragraph 13

By Lucia Mutikani

WASHINGTON, June 11 (Reuters) - U.S. producer prices increased more than expected in May, leading to the largest annual gain in 3-1/2 years as the Middle East conflict boosted the cost of energy products, providing more evidence that inflation pressures were building up.

The report from the Labor Department on Thursday and continued labor market resilience amid relatively low layoffs reinforced economists' expectations that the Federal Reserve would keep interest rates unchanged into 2027 and for the Federal Open Market Committee to ditch its easing bias at next week's policy meeting.

After oil prices retreated in recent weeks, economists had hoped inflation would peak in May. But oil prices have resumed their upward trend as a ceasefire frayed.

President Donald Trump said on Thursday the U.S. would hit Iran "very ‌hard tonight" and will soon take control ​of the country's oil and ⁠gas infrastructure and markets. Trump later said he had canceled the plans, citing negotiations with Tehran.

The government reported on Wednesday that consumer inflation jumped above 4% in May for the first time in three years.

"The Fed is clearly missing its inflation target by a lot more than it is missing its employment objective," said John Ryding, chief economic advisor at Brean Capital. "The PPI report should further embolden those on the FOMC who think a rate hike might be needed later in the year."

The Producer Price Index for final demand advanced 1.1% last month after a downwardly revised 1.1% surge in April, the Labor Department's Bureau of Labor Statistics said.

Economists polled by Reuters had forecast the PPI climbing 0.7% after a previously reported 1.4% jump in April. In the 12 months through May, the PPI advanced 6.5%, the biggest gain since November 2022. The PPI rose 5.7% year-on-year in April.

The U.S. central bank tracks the Personal Consumption Expenditures price indexes for its 2% inflation target. The PPI report prompted economists to upgrade their estimates for May PCE inflation.

The conflict, now in its fourth month, has raised prices of energy products, including gasoline and diesel. Global supply chains have been strained by the restriction of shipping in the Strait of Hormuz, causing shortages of a wide range of goods, including fertilizers, aluminum and consumer products.

A 2.8% increase in the price of goods, mostly energy products, accounted for nearly 80% of the rise in the PPI. That was the largest gain since the government started tracking the series in December 2009 and followed a 1.9% advance in April.

Energy prices soared 10.7%, with the cost of gasoline surging 23.4%. There were increases in diesel, jet fuel, plastic resins and materials, industrial chemicals and natural gas liquids prices. Food prices shot up 0.6%, boosted by higher costs for fresh fruits and melons, fresh and dry vegetables, grains and oilseeds. But wholesale pork prices dropped 10.1%.

Stocks on Wall Street rallied on Trump's comments. The dollar eased versus a basket of currencies. U.S. Treasury yields fell.

INFLATION IS BROADENING OUT

Excluding energy and food, goods prices rose 0.8%, the largest increase since April 2022. The so-called core goods prices gained 0.7% in April. A measure of core PPI, which strips out trade services, accelerated 0.8%, also the largest advance in just over four years. The core PPI rose 0.5% in April.

Wholesale services prices climbed 0.3% after advancing 0.7% in April. A 4.8% surge in prices for portfolio management fees, reflecting a stock market rally, accounted for more than 40% of the rise in the cost of services.

But margins received by wholesalers and retailers fell, supporting economists' views the pass-through from tariffs was almost over. Some said refunds after the U.S. Supreme Court struck down the duties suggested consumers would probably not immediately see price rises as large as the producer inflation.

"But the rise in energy prices and related costs is too big for consumers to be shielded for long," said Samuel Tombs, chief U.S. economist at Pantheon Macroeconomics.

The cost of transporting freight by road increased 3.4% while airline fares surged 2.5%. Hospital inpatient care prices rose 0.5% while the cost of hotel and motel rooms accelerated 2.3%. Portfolio management fees, airline fares, hotel and motel rooms are among the components that go into the calculation of the core PCE price index.

Economists raised their estimates for the May PCE price index to as high as 0.5%, after rounding, from around 0.4% earlier. The PCE price index increased 0.4% in April. It was forecast advancing 4.1% in the 12 months through May, up from 4.0% before the PPI data. PCE inflation was 3.8% in April.

Monthly core PCE inflation was projected to have risen to 0.4% after rounding, up from about 0.3% before the data and 0.2% in April. That would translate to a year-on-year increase of 3.4%. Core prices increased 3.3% in April.

A separate report from the Labor Department showed initial claims for state unemployment benefits rose 4,000 to a seasonally adjusted 229,000 for the week ended June 6.

Claims tend to rise at the start of summer as some states allow non-teaching staff to file for unemployment benefits during the long school holidays. Seasonal factors, the model used by the government to strip out seasonal fluctuations from the data, do not always capture these moves.

The economy notched a third straight month of strong employment gains in May, the government reported last week.

Rising inflation and labor market stability have led financial markets to price in a rate increase from the Fed. But economists still view the bar as high for policy tightening. The Fed is next Wednesday expected to keep its benchmark overnight interest rate in the 3.50%-3.75% range.

"The upward pressures on inflation combined with the firming of job gains should keep the Fed on the sidelines until 2027, although the odds of a rate hike in 2026 are still low," said Ben Ayers, senior economist at Nationwide.