U.S. Consumer prices rose in January for the first time in six months as energy costs rebounded, government data showed on Friday, easing fears of deflation amid a severe economic downturn.

The Labor Department said its closely-watched consumer price index rose 0.3 percent after dropping 0.8 percent in December. The modest uptick followed months of aggressive discounting by retailers seeking to stimulate sales.

Analysts said difficulties adjusting the data to take into account new price setting at the start of the year was likely behind the small, but broad-based, bounce, adding that inflation was likely still in a downward trend.

The price rises may allay deflation fears temporarily, but they probably reflect a temporary bounce at the start of the year after severe discounting during the holiday season. Deflation risks remain, said Nigel Gault, chief U.S. economist at IHS Global Insight in Lexington, Massachusetts.

Fears that U.S. government's plans to rescue the fractured financial system could eventually involve nationalizing banks eclipsed the data.

The Dow Jones industrial average extended losses on Friday, and has fallen to levels last seen earlier this decade as investors snapped up government bonds to protect their money.

A deepening recession has been pushing unemployment higher, squeezing households' spending capacity and creating an environment in which the risk of falling prices is rising.

On a year-over-year basis, consumer prices were flat last month, marking the weakest 12-month reading since August 1955. The index rose 0.1 percent year-on-year in December.

DEFLATION THREAT

The drop in inflation has largely reflected a plunge in energy prices as global demand slumped. But even core inflation, which strips out volatile food and energy costs, has been slowing.

Core prices were up 1.7 percent in January from a year ago, a slight slowing from December's 1.8 percent but well off the 2.5 percent rise seen as recently as September.

On a month-on-month basis, however, core prices rose 0.2 percent after coming in flat in December. Prices were lifted by gains in rental, new vehicles and apparel costs, which analysts said did not make sense in the current harsh economic climate.

About 80 percent of the change in CPI, ex-food and energy, was caused by higher rents and car prices. Frankly this is ridiculous because we know that car dealers have slashed prices in order to push their sales, said Harm Bandholz, economist at Unicredit Markets and Investment in New York.

The increase in core inflation is not sustainable. The underlying deflation threat is still there, he added.

Deflation is a broad-based decline in prices that can undercut an economy by leading consumers to hold off purchases in the hopes of even lower prices, creating a precarious spiral. Falling prices also raise the real burden of debt.

Energy prices rebounded 1.7 percent in January, reversing five consecutive months of declines. But compared to the same period a year earlier, energy prices tumbled 20.4 percent.

The Federal Reserve said on Wednesday that most policy-makers at the U.S. central bank want to see inflation in a 1.7 percent to 2 percent range over the long term.

Some officials hope announcing what amounts to a de facto target for inflation would help keep any expectations of deflation at bay. If expectations of deflation were to build, they could become self-fulfilling, analysts warn.

(Editing by Gary Crosse)

Inflation