U.S. retail sales fell more than expected in August amid weak purchases of automobiles and a range of other goods, pointing to cooling domestic demand that further diminishes expectations of a Federal Reserve interest rate increase next week.

Other data on Thursday showed the labor market continuing to tighten with layoffs remaining very low last week, and underlying producer inflation creeping up in August. 

Coming on the heels of reports showing a slump in manufacturing activity in August and a slowdown in job growth, the retail sales data could temper hopes of a strong rebound in economic growth in the third quarter. 

"Continued momentum in household spending is an important component in the Federal Reserve's growth narrative and the softening in the third quarter is consistent with the theme of patience. A September hike is simply too soon," said Brittany Baumann, an economist at TD Securities in Toronto.

The Commerce Department said retail sales declined 0.3% after edging up 0.1% in July. Sales were up 1.9% from a year ago. Excluding automobiles, gasoline, building materials and food services, retail sales slipped 0.1% last month after a similar drop in July.

These so-called core retail sales correspond most closely

with the consumer spending component of gross domestic product. 

Economists had forecast overall retail sales slipping 0.1% and core sales climbing 0.3 percent last month.

The weak report could encourage the Fed to keep interest rates unchanged at its Sept. 20-21 policy meeting. Fed Governor Lael Brainard said on Monday she wanted to see stronger consumer spending data and signs of rising inflation before hiking rates.

The U.S. central bank raised its benchmark overnight interest rate at the end of last year for the first time in nearly a decade, but has held it steady since amid concerns over persistently low inflation.

Financial markets are pricing in only a 12% probability of a rate hike next week, down from 15% before the data, according to the CME FedWatch tool. The dollar was trading higher against a basket of currencies, while prices for U.S. government debt fell. U.S. stocks were marginally higher.

FIRMING INFLATION 

The Fed could still raise interest rates as inflation pressures are gradually firming. A separate report from the Labor Department showed producer prices, excluding food, energy and trade services, increased 0.3 percent in August after being unchanged in July. 

The so-called core PPI increased 1.2% in the 12 months through August, the biggest gain since December 2014. It increased 0.8% in June.

The decline in retail sales last month was led by a 0.9% fall in receipts at auto dealerships. Sales at service stations dropped 0.8%. Households also cut back on discretionary spending, with sales at online retailers slipping 0.3% and receipts at sporting goods and hobby stores decreasing 1.4%. 

There were also declines in sales at furniture and building material stores. Receipts at clothing stores, however, rose 0.7%. Sales at electronics and appliance outlets gained 0.1% and receipts at restaurants and bars rose 0.9 percent.

Despite the drop in retail sales last month, consumer spending will likely remains supported by a strong labor market.

In a separate report, the Labor Department said initial claims for state unemployment benefits edged up 1,000 to a seasonally adjusted 260,000 for the week ended Sept. 10.

It was the 80th straight week that claims remained below the 300,000 threshold, which is associated with robust labor market conditions. That is the longest stretch since 1970, when the labor market was much smaller.

The tightening labor market is pushing up wages, with a government report on Tuesday showed a record increase in household income in 2015.

Robust consumer spending helped to blunt the blow on the economy from an inventory correction and prolonged drag from

lower oil prices and a strong dollar, which restricted GDP growth to a 1.1% annualized rate in the second quarter.

The Atlanta Fed is currently forecasting the economy growing at a 3.3% rate in the third quarter. 

Adding to the raft of weak August reports, data from the Fed showed manufacturing output fell 0.4% in August, reversing July's increase. 

Output was hurt by declines in the production of nondurable goods. While many durable goods industries posted declines of nearly 1% or more, motor vehicle assembly increased.

There was good news from mining, where output rose 1.0%. Oil and gas well drilling rose for a third straight month in August.