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* U.S. inflation unchanged, retail sales fall
* U.S. consumer sentiment index slips as well
* December rate hike expectations fall after U.S. data (New throughout, updates prices and market activity, adds comment, table)
By Gertrude Chavez-Dreyfuss
NEW YORK, July 14 (Reuters) - U.S. Treasury yields dropped to multi-week lows on Friday as benign U.S. inflation data in June and surprise fall in retail sales clouded expectations about an interest rate increase later this year.
Yields, which move inversely to prices, on the benchmark 10-year note, including those on the 3-year and 7-year notes fell to two-week lows. U.S. two-year note yields, most sensitive to rate hike expectations, tumbled to three-week lows.
U.S. inflation was unchanged in June, following a 0.1 percent dip in May. The so-called core CPI, which strips out food and energy costs, edged up just 0.1 percent in June. The core CPI increased 1.7 percent year-on-year after a similar gain in May.
U.S. retail sales also underperformed, falling for a second month in June. Retail sales dropped 0.2 percent last month.
The rate futures market saw a 47 percent chance the Federal Reserve would raise key overnight borrowing costs by at least a quarter point at its Dec. 12-13 meeting, down from about 55 percent at Thursday's close, according to the CME Group's FedWatch.
Eric Winograd, senior economist at Alliance Bernstein in New York, still believes the weakness in U.S. core inflation was not enough to change the Federal Reserve's course for raising interest rates.
"They will get two more CPI prints and two more PCE (personal consumption expenditures) prints before the September meeting so they will have a lot more information before having to make a decision," said Winograd.
"Because I think the Fed's expectation that inflation will gradually rise from here is correct. I still think that a September announcement on the balance sheet is likely and that a rate hike in December is the base case.
The U.S. consumer sentiment index also took a dip this month, with a 93.1 reading, from the previous month's 95.1, highlighting the overall bearish tone of Friday's U.S. data.
In late trading, the U.S. 10-year yield fell to 2.324 percent, from 2.348 percent late on Thursday. It earlier fell to 2.279 percent, its lowest since June 30.
U.S. two-year yields slid as well, down to 1.355 percent , from Thursday's 1.367 percent, after sliding to a three-week trough of 1.323 percent.
The yield gap between shorter-dated and longer-dated Treasuries shrank on Friday after the data, with the spread between 2-year and 10-year yields at 96.70 basis points, its flattest level in more than a week.
A flat yield curve suggests investors are buying long-dated securities because there is no fear of inflation. (Editing by Bernadette Baum; Editing by David Gregorio)