An ailing Treasury market dragged municipals 1/8 to 1/4 point lower yesterday as most eyes turned toward the key inflation reports due out today and tomorrow.

"It's faded down just in sympathy with governments," a municipal trader said, "Our market by itself I don't think is in bad shape."

A second trader said he saw more potential buyers "on the distressed bid side than there are sellers ... The problem is no one wants to sell at [those] levels."

He estimated that customer bid lists totaled $300 million yesterday.

In a moderately active session, yields on high-grade bonds rose by two basis points overall, while dollar bonds lost 1/4 point, a municipal analyst said.

In debt futures, the September municipal contract settled up 1/32 to 88 25/32s. Yesterday's September MOB spread was negative 369, compared to negative 378 on Friday. 1

The Treasury's 30-year bond hit a 22-month low yield of 7.75%, but later rebounded. The long bond closed slightly more than 1/4 point lower to yield 7.71%.

"The dollar is really the story of the day today," said Marilyn Schaja, a money market economist at Donaldson, Lufkin & Jenrette Securities Corp. "The dollar and the CRB [Commodities Research Bureau's index]."

The woes of the greenback continued yesterday after no dollar support package came out of the weekend's Group of Seven economic summit in Naples. The CRB shot up 2.43 points yesterday.

Today, the market receives the producer price index report for June.

Most economists are looking for a 0.2% increase in both the overall and core PPI rates. The June consumer price index arrives tomorrow, with a 0.3% rise expected in both the overall and core rates.

"I am right in line with that," Schaja said.

While it's unlikely that the Fed would move to tighten credit immediately, a core CPI reading of plus 0.4% or more would make a stronger case for Fed action before the next Federal Open Market Committee meeting on Aug. 16.

Christopher Rupkey, an economist at Mitsubishi Bank, sees a 0.3% rise in the overall PPI, and a 0.1% rise in the core rate.

The rise in gasoline prices that began in March will help boost overall PPI for June, Rupkey said. gasoline price will not affect the core rate, which excludes food and energy. The core is also expected to be nudged lower as tobacco prices reverse the gains recorded in May, he said.

A municipal trader yesterday said it appeared that the Street was expecting the core inflation indexes to be favorable to the bond market, but he expressed fear over what could happen should that not be the case.

Elsewhere yesterday, George D. Friedlander, a managing director at Smith Barney Inc. said zero coupon bonds continue to look attractive. In the general market, zero coupon bonds yield 25 to 30 basis points more than comparable current coupon paper. In specialty states, however, the spread between zeros and comparable current coupon paper is narrower, because zeros are in greater demand, he said.

In a report issued last month, Friedlander said that as rates declined through last October, investors became increasingly less willing to lock in yields for the life of an investment, as they would have to do with zeros. When rates picked up, zeros continued to gather dust on shelves as investors spurned high duration investments, he said.

In other news, Standard & Poor's Blue List inventory of municipal bonds rose up $9.4 million yesterday to $1.77 billion.

The 30-day visible supply of municipal bonds for today totals $7.89 billion, up $240 million from yesterday. The total marks a new high for 1994. The comprises $5.80 billion of competitive bonds, up $122 million from yesterday, and $2.08 billion of negotiated bonds, up $118 million..

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