U.S. consumers' gloom deepened in early August as worry about scarce jobs and falling income overshadowed positive news that industrial output in July grew for the first time in nine months.

The latest data on Friday pointed to a sluggish recovery at best with little or no help to come from embattled consumers.

The Reuters/University of Michigan Surveys of Consumers said on Friday its preliminary reading of the index of confidence fell to 63.2 from 66.0 in July, well below market expectations for a reading of 68.5.

Financial market participants focused on the bleak consumer outlook instead of a Federal Reserve report that seemed to imply the deep recession that started in December 2007 was close to ending.

Consumer sentiment ebbed for a second straight month as households, battered by high unemployment and falling home values, gave less favorable views their personal finances.

The erosion in confidence, coming a day after a government report showed an unexpected drop in retail sales added to fears that consumers would not drive the anticipated recovery from the worst recession since the Great Depression, leaving the economy vulnerable to a double dip.

Even though economic output is probably increasing again, consumers certainly appear to still be in a funk. This is not entirely surprising given how many jobs are still being lost, said Abiel Reinhart, an economist at JP Morgan in New York.

Consumers fuel about 70 percent of U.S. economic activity.

The weak sentiment report and news that flaws had stopped work on Boeing Co's long-delayed, next generation jetliner, pushed the Dow Jones industrial average <.DJI> down 0.82 percent to 9,321.40. The Standard & Poor's 500 index <.SPX> shed 0.82 percent to 1,004.09.

Government debt prices rallied as investors sought a safe-haven and were also buoyed by a report showing inflation was muted in July. The benchmark 10-year note rose 11/32 for a yield of 3.56 percent, down from 3.60 percent late on Thursday.

BRIGHT SPOTS IN THE SURVEY

There were a few bright spots in the consumer survey report, including a rebound in the home buying conditions index, and households' outlook for the labor market was less negative than in the prior month.

The survey suggests that households sense the economy is beginning to stabilize but they have not yet seen improvement in their own personal situation, and they probably won't until the labor market begins to firm, said Michelle Girard, an economist at RBS in Greenwich, Connecticut.

Separately, industrial output rose 0.5 percent, beating market expectations for 0.3 percent advance, after a 0.4 percent contraction in June. Aside from a hurricane-related rebound in October 2008, it was the first monthly gain since December 2007, the Fed said.

Industrial production was boosted as Chrysler and General Motors reopened plants that had been temporarily closed while the companies were under bankruptcy protection to reorganize, Fed data showed.

It was also lifted by the government's cash-for-clunkers program, which gives consumers a credit for trading in aging high fuel consuming vehicles for new fuel efficient models.

The increase in industrial production is yet another indication that the U.S. recession is drawing to a close, said Harm Bandholz, economist at UniCredit Markets and Investment Banking in New York.

Analysts worry that, with consumers keeping a low profile, a hoped-for recovery in the second half may be unsustainable.

Growth is spurred temporarily by government initiatives, such as the cash-for-clunkers program, which further lifts the prospect for auto production. As those programs will taper off, the upswing will turn from a V-shaped into a more volatile W-shaped recovery, said Bandholz.

Manufacturing output rose 1 percent in July as motor vehicle assemblies rose to an annual rate of 5.9 million units in July from 4.1 million in June. Excluding autos and parts, industrial output fell 0.1 percent in July, the Fed said.

The capacity utilization rate, a measure of slack in the economy, edged up to 68.5 percent, but is still 12.4 percentage points below the 1972-to-2008 average.

Analysts reckon the slack in the economy will keep inflation pressures muted for a while.

In another report, the Labor Department said U.S. consumer prices were flat in July and dropped over the past 12 months at the fastest rate since 1950.

The Fed this week left its key overnight lending rate steady near zero, saying substantial resource slack was likely to dampen price pressures and it expected inflation to remain subdued for some time.

Stripping out volatile energy and food prices, the closely watched core measure of consumer inflation rose 0.1 percent in July after increasing 0.2 percent in June.

Compared to July last year, the core inflation rate rose 1.5 percent, the slowest advance since February 2004, after increasing 1.7 percent in June.

(Additional reporting by Emily Kaiser in Washington and Ciara Linnane in New York; Editing by XX)

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