Weak energy costs pushed U.S. consumer prices down for a third straight month in June while consumer sentiment dropped to a near one-year low in July, highlighting the sluggishness of the economic recovery.

However, prices excluding food and energy rose 0.2 percent, their largest monthly gain since October, the Labor Department said on Friday. Analysts said that suggested deflation risks were easing and called it further proof the economy was not slipping back into recession.

We are seeing some loss of momentum in growth, but it's not the start of a double-dip. The core inflation number should lessen deflation fears, the economic recovery is still intact, said Jim O'Sullivan, chief economist at MF Global in New York.

The Consumer Price Index dipped 0.1 percent last month after falling 0.2 percent in May. Analysts had expected consumer prices to hold steady.

Energy prices fell 2.9 percent and food prices were flat.

But a rise in rental costs after months of stagnation allowed the core CPI to move higher. The core rate had risen 0.1 percent in May and markets had expected a similar gain last month.

Analysts said the rental costs' increase was encouraging and reflected a labor market that was starting to create jobs, although at a pedestrian pace.

A second report showed consumer sentiment early this month pulled back from a near 2-1/2 year high on worries about income and jobs. The Thomson Reuters/University of Michigan's consumer sentiment index plummeted to 66.5 from 76.0 in June. That was below market expectations for 74.5.

Prices for safe-haven U.S. government debt rallied as investors viewed the data as suggesting the Federal Reserve would keep interest rates near zero well into 2011. The U.S. dollar fell to a seven-month low against the yen.

The dour confidence report and weak revenues from corporate giants Bank of America, Citigroup and General Electric hammered stocks on Wall Street. Major U.S. stock indices ended down more than 2.5 percent.

MODEST RECOVERY

It points to the simple fact that this recovery is modest at best. Businesses do not have pricing power, said Joel Naroff of Naroff Economic Advisors in Holland, Pennsylvania. Consumers are still concerned about the recovery, they are not going to shop till they drop.

Consumer prices have not declined for three successive months since October-December 2008. In the 12 months to June, the CPI rose 1.1 percent, the smallest advance since October, and a sharp slowdown from the 2 percent in the period through May.

Recent data ranging from consumer spending to manufacturing imply the recovery from the longest and deepest recession since the 1930s has come close to stalling in recent months.

With inflation subdued, the unemployment rate at a lofty 9.5 percent and domestic demand lackluster, economists say the U.S. central bank should not have to raise interest rates before the second half of next year.

Wholesale price readings have also suggested scant inflation pressure. Prices received by farms, factories and refineries fell for a third straight month in June, the government said on Thursday.

Minutes of the Fed's last policy meeting, released on Wednesday, showed a few officials have begun to worry about the risk of deflation -- an economically disabling, broad-based decline in consumer prices.

Others, however, have argued that the U.S. economic recovery appears on solid ground and believe inflation is unlikely to fall much more.

Indeed, some economists said the CPI report suggested core inflation, which slowed sharply during the recession, may have already bottomed.

I don't see deflation as an issue. I don't see inflation as an issue. I just see modest to moderate inflation for at least six to twelve months, said Naroff.

Although retail sales have dropped for two months in a row, retailers are still managing to squeeze through price increases, the inflation report showed.

The monthly core inflation rate was bumped up by a 0.8 percent in apparel costs, the largest increase in 16 months. Used cars and trucks, which rose 0.9 percent last month, also contributed to the rise in core inflation, as did a 1 percent rise in tobacco prices.

In the 12 months to June, the core inflation rate rose 0.9 percent, increasing by the same margin for a third straight month. The rise was in line with market expectations and matched the lowest core inflation rate since January 1966.

Most Fed officials would like to see inflation in a 1.7 percent to 2 percent range.

(Additional reporting by Richard Leong in New York; Editing by Kenneth Barry)

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