By Lucia Mutikani
WASHINGTON (Reuters) - Inflation slowed to a half-century low this past year and industrial output fell for the first time since 2002, data showed on Friday, as the recession deepened toward year-end, raising the specter of deflation.
With consumer confidence remaining at depressed levels, the reports suggested the economy could take longer to pull out of a downturn that is on track to be the longest and possibly deepest since World War Two.
"We seem to be digging an economic hole of major proportion which will only add time to the turnaround," said Kevin Giddis, head of fixed-income sales, trading and research at Morgan Keegan in Memphis.
The Consumer Price Index dropped 0.7 percent in December, a third straight monthly decline, capping a year in which prices advanced only 0.1 percent -- the weakest 12-month reading since December 1954, the Labor Department said.
Weakening activity worldwide has depressed commodity prices, pulling headline inflation down sharply. However, core U.S. inflation, which strips out volatile food and energy costs, is also slowing increasing the risk of deflation.
Markets were little moved by the data, which was overshadowed by an announcement overnight of more U.S. government aid to Bank of America. Wall Street stocks opened higher, taking some steam out of U.S. government bond prices and the dollar.
DEFLATION EYED
"Deflation is just around the corner," said Meny Grauman, an economist at CIBC World Markets in Toronto.
"With the U.S. economy roughly one full year into a deep recession, the prospect of deflation is a concern for another time, especially on a day when the U.S. government has decided to inject billions more into the U.S. banking system."
Deflation is usually described as a dangerous spiral of falling prices causing economic contraction as consumers hold off purchases in the hopes of even lower prices.
Mounting job losses, falling household wealth and tight credit conditions have forced consumers to hold back on spending, limiting businesses' ability to raise prices and encouraging some to offer heavy discounts to lure customers.
With consumers retrenching, industry is cutting back sharply.
The Federal Reserve said on Friday that U.S. industrial production dropped 2 percent last month, capping a dismal year for manufacturing as the recession took hold.
For the fourth quarter, industrial output fell at an 11.5 percent annualized rate.
Compared with December 2007, industrial production was down 7.8 percent, the biggest 12-month drop since September 1975.
Analysts said the data illustrated the urgent need for a massive fiscal injection to turnaround the economy. President-elect Barack Obama and Congress are working on a package of spending and tax-cut measures to stimulate demand.
"There is little hope of a near-term revival in manufacturing without a huge fiscal stimulus program implemented with a sense of urgency," said Roger Kubarych, an economist at Unicredit Markets and Investment Banking in New York.
AGGRESSIVE ACTION
The Fed has dropped benchmark interest rates virtually to zero and with little firepower left on that front, is concentrating on pumping money into troubled credit markets to try to restore lending, hoping to spur activity and beat back incipient deflation risks.
Core prices, which exclude food and energy items, were flat for the second month in a row in December. On a year-over-year basis, core inflation rose 1.8 percent, the smallest increase since December 2003 and still within a range Fed officials would be comfortable with.
Energy prices fell 8.3 percent in December, after declining 17 percent the prior month. Compared to the same period last year, energy prices were down a record 21.3 percent.
The gasoline index slid 17.2 percent and accounted for almost 90 percent of the decrease in headline CPI, the Labor Department said.
Falling gasoline prices have contributed to a small uptick in consumer confidence in January, but sentiment remained at comparatively depressed levels. The Reuters/University of Michigan Surveys of Consumers' preliminary index reading of confidence for January rose to 61.9 from December's 60.1.
Sharply slowing global growth has dampened demand for oil, driving down the price from a record peak of $147 a barrel touched last July.
(Additional reporting by Emily Kaiser in Washington and Chris Reese in New York; writing by Lucia Mutikani and Tim Ahmann; editing by Gary Crosse)
