By Lucia Mutikani

WASHINGTON (Reuters) - U.S. retail sales fell more than expected in March as consumers cut back on purchases of motor vehicles and other big-ticket items, suggesting that the economy was losing steam at the end of the first quarter because of higher interest rates.

With the labor market cooling, retail sales are likely to remain weak. Ebbing demand for goods is undercutting production at factories, with other data on Friday showing manufacturing production declining last month. Still, the Federal Reserve is poised to raise rates one more time in May, before an anticipated pause in June in the U.S. central bank's fastest monetary policy tightening cycle since the 1980s.

"Households are clearly feeling the pinch from rising interest rates and the extended period of high inflation and are reducing expenses to compensate," said Ben Ayers, a senior economist at Nationwide in Columbus, Ohio. "While job and income gains remain strong, the cracks in the consumer sector are widening and a negative shift in hiring activity could be the final blow to place the economy in a recession."

Retail sales dropped 1.0% last month, the Commerce Department said. Data for February was revised up to show retail sales falling 0.2% instead of 0.4% as previously reported. Economists polled by Reuters had forecast sales slipping 0.4%. They increased 2.9% year-on-year in March.

Retail sales are mostly goods, which are typically bought on credit, and are not adjusted for inflation. The second straight monthly decrease followed a sharp surge in January.

It coincided with the expiration of a temporary boost to the Supplemental Nutrition Assistance Program (SNAP) benefits authorized by the U.S. Congress to cushion low-income people and families against the hardships of the COVID-19 pandemic.

SNAP is commonly known as food stamps. Morgan Stanley estimated that the expiration of the emergency program resulted in about a $4 billion non-annualized hit to income.

"The expiration of SNAP benefits is another catalyst that will lead consumers at the lower end of the income spectrum to become more cautious spenders and allocate a greater share of their wallet away from discretionary items," said Ellen Zentner, chief U.S. economist at Morgan Stanley in New York.

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The decline in retail sales was almost across the board. Receipts at auto dealers dropped 1.6%. Furniture store sales fell 1.2%, while receipts at electronics and appliance stores tumbled 2.1%. Sales at building material and garden equipment supplies dealers plummeted 2.1%.

Receipts at clothing outlets dropped 1.7%. Lower gasoline prices depressed sales at service stations, which plunged 5.5%. Sales were down 0.6% excluding gasoline service stations.

But online retail sales jumped 1.9%, likely as price-conscious consumers sought discounts and deals. Spending on hobbies and grooming increased moderately. Sales at food services and drinking places, the only services category in the retail sales report, edged up 0.1%. Economists view dining out as a key indicator of household finances.

It was unclear whether a tightening in credit conditions in March following the failure of two regional banks had impacted retail sales. But reduced access to credit was seen weighing on sales in the months ahead.

Consumer sentiment improved in April, but higher-income households grew more pessimistic, a separate report showed on Friday.

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The pullback in retail sales is mostly attributed to the Fed's year-long interest rate hiking campaign, which is slowing inflation by cooling domestic demand. Reports last week showed employment growth and services sector activity slowing in March.

Inflation could continue to retreat, with a third report from the Labor Department showing import prices dropping 0.6% in March after slipping 0.2% in February. That resulted in import prices plunging 4.6% in the 12 months through March, the largest year-on-year drop since May 2020.

Stocks on Wall Street were trading lower. The dollar rose against a basket of currencies. U.S. Treasury prices fell.

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The Fed has hiked its policy rate by 475 basis points since last March from the near-zero level to the current 4.75%-5.00% range. Financial markets are betting on another 25 basis point increase at the Fed's May 2-3 policy meeting, according to CME Group's FedWatch tool.

Excluding automobiles, gasoline, building materials and food services, retail sales slipped 0.3% last month. These so-called core retail sales increased by an unrevised 0.5% in February.

Core retail sales correspond most closely with the consumer spending component of gross domestic product. Despite March's fall, the gains in January and February put consumer spending firmly on track to accelerate in the first quarter.

But the weak core sales set consumer spending on a lower growth path heading into the second quarter.

Consumer spending, which accounts for more than two-thirds of U.S. economic activity, grew at its slowest pace in 2-1/2 years in the fourth quarter. Economic growth estimates for the first quarter are mostly above a 2% annualized rate. The economy expanded at a 2.6% pace in the October-December quarter.

A fourth report from the Fed showed manufacturing production dropped 0.5% in March after increasing 0.6% in February. Motor vehicle output fell 1.5%. Excluding autos, manufacturing production also decreased 0.5%.

The weakness, combined with banks tightening lending standards does not bode well for business investment.

"This is a warning sign that the share of manufacturing industries contracting is on the rise, a bad omen for the economy," said Ryan Sweet, chief economist at Oxford Economics.

Manufacturing, which accounts for 11.3% of the economy, is also being hurt by the shift in spending from goods to services. Businesses are holding excess inventory as demand slows, reducing the incentive to place more orders with factories.

The reluctance by businesses to accumulate more inventory could also exert downward pressure on GDP growth. A fifth report showed business inventories rising slightly in February.

"Because inventories are a stock, it's the change that matters for GDP," said Sweet. "So, even a slowdown from the recent rapid inventory build has the potential to weigh heavily on economic growth in the first half of this year."

(Reporting by Lucia Mutikani; Editing by Chizu Nomiyama and Andrea Ricci)