WASHINGTON U.S. producer prices fell more than expected in May and the annual increase in producer inflation was the smallest in nearly 2-1/2 years, strengthening the case for the Federal Reserve to skip raising interest rates on Wednesday.

The producer price index for final demand dropped 0.3% last month on lower energy costs after rising by an unrevised 0.2% in April, the Labor Department said on Wednesday.

In the 12 months through May, the PPI climbed 1.1%. That was the smallest year-on-year rise since December 2020 and followed a 2.3% increase in April. The annual PPI rate is moderating as last year's surge drops out of the calculation.

Economists polled by Reuters had forecast the PPI dipping 0.1% from the prior month and rising 1.5% on year.

The report followed data on Tuesday showing consumer prices edging up in May. The year-on-year increase in the consumer price index was the smallest since March 2021.

Fed officials are expected to keep rates unchanged at the end of their two-day meeting, for the first time since March 2022 when the U.S. central bank embarked on its fastest monetary policy tightening campaign in more than 40 years.

The Fed, which has hiked its policy rate by 500 basis points in this tightening cycle, was seen leaving the door open to further rate increases given the economy's resilience, particularly the labor market.

(Reporting By Lucia Mutikani; Editing by Chizu Nomiyama)