WASHINGTON (Reuters) - Wholesale prices shot up in July at the fastest year-on-year rate since 1981, while home builders cut back on construction as they worked through a glut of unsold homes, government data showed on Tuesday.

The reports offered little solace to the U.S. Federal Reserve, which is hoping that a slowing economy will cool inflation so that the central bank can hold off on raising interest rates.

The Labor Department's Producer Price Index, which measures prices at the factory door, climbed 1.2 percent after a 1.8 percent gain in June. So-called core producer prices, which exclude food and energy, jumped 0.7 percent in July after a 0.2 percent June increase.

Economists polled by Reuters had expected producer prices to rise just 0.6 percent in July, and had forecast that core prices would be up only 0.2 percent. A sharp decline in oil prices since mid-July led many investors to conclude that inflation pressures were subsiding.

The steep jump in core prices rattled financial markets, driving stock futures down. The dollar gained in value on the prospect of higher rates.

"There's nothing good about it," said Marc Pado, U.S. market strategist at Cantor Fitzgerald & Co in San Francisco. "Inflation is more systemic than they were leading us to believe in the past numbers and it will continue to show up in the CPI number for months to come. The question is whether or not investors can shake it off knowing that the price of oil has come down.

"The Fed is stuck between a rock and a hard place, and it shows," he added.

Separately, the Commerce Department reported that U.S. home building projects started in July fell 11 percent to the lowest annual rate in more than 17 years, while building permits tumbled 17.7 percent.

The annual pace of housing starts at 965,000 was slightly above Wall Street's expectations of 960,000, but it was the lowest since a 921,000 unit rate in March 1991. In June, housing starts rose 10.4 percent, revised up from the previously reported 9.1 percent gain.

Building permits, an indicator of future construction, dropped to an annual rate of 937,000, well below the 970,000 analysts polled by Reuters had forecast. It was the lowest level since March, when they were 932,000, the Commerce Department said.

Single family homes, which constitute the bulk of new housing, were especially weak. The annual unit rate of 641,000 single family homes started in July was the lowest since January 1991, when they were 604,000. Building permits were 584,000, the lowest since 523,000 in August 1982.

(Additional reporting by Herb Lash in New York; Writing by Emily Kaiser; Editing by Tom Hals)

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