By Lucia Mutikani
WASHINGTON (Reuters) - U.S. consumer prices recorded their biggest drop in six years in December and a gauge of underlying inflation was flat, which could make the Federal Reserve more cautious about raising interest rates.
The Labor Department said its Consumer Price Index fell 0.4 percent last month, the largest decline since December 2008, after sliding 0.3 percent in November.
In the 12 months through December, the CPI increased just 0.8 percent, the weakest reading since October 2009 and a sharp deceleration from November's 1.3 percent rise.
"The odds of a rate hike in June are fading fast," said Michelle Girard, chief economist at RBS in Stamford, Connecticut. "The recent data cannot leave the Fed feeling more confident that inflation will move higher."
While Fed officials have viewed the energy-driven drop in inflation as transitory, a strong dollar is taming underlying price pressures, which could cause them some discomfort.
The so-called core CPI, which strips out food and energy costs, was unchanged in December. It was only the second time since 2010 that it did not increase.
In the 12 months through December, the core CPI rose 1.6 percent, the smallest gain since February.
Other data on Friday, however, suggested the economy was growing solidly despite the soft inflation readings, with factory output rising last month and consumer sentiment hitting its highest level in 11 years in January.
Fed officials will need to navigate these conflicting signals as they near a decision on when to raise benchmark borrowing costs from near zero, where they have been pegged since December 2008.
"Maybe the data would push us a little bit further one way or the other," San Francisco Federal Reserve Bank President John Williams told a group of business people in San Francisco.
"But I think the good news here is that the economy has improved a lot ... and in fact we are able to start adjusting policy, tightening policy in a way because of that strength."
Despite a strengthening labor market and economy, inflation does not look like it will reach the U.S. central bank's 2 percent target anytime soon. Indeed, some economists think it could dip into negative territory this year before rebounding.
The softness in core inflation, however, along with darkening prospects for the global economy, is likely more troubling for the Fed.
The 11-year high in consumer sentiment in January reported by the University of Michigan reflected gains in both employment and income, and the boost to spending power from sharply falling gasoline prices.
A separate report from the Fed showed factory output rose 0.3 percent last month, a fourth straight monthly gain. Mining output jumped 2.2 percent on increased oil and gas extraction. Drilling activity, however, fell.
The better prospects for the economy helped to lift U.S. stocks, while prices for U.S. government debt fell. The dollar rose against a basket of currencies.
Weaker global demand and increased shale production in the United States have caused an oil glut, sending crude prices tumbling. Brent crude prices neared a six-year low this week.
In the United States, gasoline prices last month registered their biggest drop in six years. The cost of gasoline has now declined for six straight months.
Food prices rose for the 12th month. Elsewhere, shelter costs increased 0.2 percent, while the rise in medical care commodities prices was the largest since May 1989.
Apparel prices, however, recorded their biggest decline since September 1998, and there were also declines in airfares, new motor vehicle and used cars and trucks prices.
(Reporting by Lucia Mutikani; Additional reporting by Ann Saphir in San Francisco; Editing by Andrea Ricci and Tim Ahmann)