U.S. consumer prices rose modestly last month, while industrial output rose on a cold snap, suggesting the economy was growing but not generating a level of inflation that would spur the Federal Reserve to roll back from its stimulative policies.

But even as Friday's data showed the recovery from the worst downturn since the 1930s was gaining traction, consumers remained cautious about the economy's prospects in the face of stubbornly high unemployment.

The Reuters/University of Michigan Surveys of Consumers' preliminary index of sentiment for January inched up to 72.8, from 72.5 in December. The reading was the highest in four months, but it fell short of market expectations.

It is still reflecting improving conditions. The question remains how will this trend continue and to what degree can we expect it to translate into higher sales, higher consumer spending, said Bill Schultz, chief investment officer at McQueen, Ball & Associates in Bethlehem, Pennsylvania.

While the economic recovery that started in the third quarter of 2009 probably gathered steam in the October-December period, there are concerns it could sputter later this year because consumers are not well positioned to take over the baton from the government.

The president of the Richmond Federal Reserve Bank, Jeffrey Lacker, said on Friday predictions the economy grew at a near 5 percent annual rate in the fourth quarter were reasonable but cautioned that such a pace would not be sustained into 2010. The economy expanded at a 2.2 percent annual rate in the third quarter.

Sluggish domestic demand is keeping inflation pressures subdued. The Labor Department said its Consumer Price Index rose 0.1 percent last month from November as food and energy costs gained only modestly and housing-related expenses held steady.

December's increase was slower than market expectations for a 0.2 percent advance and below the 0.4 percent rise in November.

COLD SPELL BOOSTS OUTPUT

Also on Friday, the Federal Reserve said industrial production rose 0.6 percent in December as electric and gas utilities stepped up output in an unusually cold month after increasing by the same margin in November.

The Fed said, however, that manufacturing production slipped 0.1 percent, disappointing expectations for a gain. Capacity utilization, a measure of slack in the economy, rose to 72.0 percent from 71.5 percent in November, but remained below its average for the period from 1972 to 2008.

Analysts were unperturbed by the dip in manufacturing, pointing to data from the New York Federal Reserve Bank that showed factory activity in New York State gained momentum this month as new orders and shipments surged.

We think manufacturing activity will be well supported during the positive phase of the inventory cycle. However, it will ultimately need to be propelled by final demand growth, said Julia Coronado, an economist at BNP Paribas in New York.

U.S. stocks ignored the economic data and fell as investors worried about JPMorgan Chase & Co's deep fourth-quarter loan losses. The losses on mortgages and commercial loans, two of the economy's weakest points, raised concerns about earnings for the banking industry.

Prices for U.S. government debt rallied on the inflation data, which underscored tame price pressures amid the slack in the economy.

That will allow the Fed to continue to hold down short-term interest rates at essentially zero and continue to have an aggressive stimulatory policy, said Robert Dye, senior economist at PNC Financial Services Group in Pittsburgh.

The Fed has kept benchmark overnight interest rates near zero for more than a year and vowed at its last meeting to hold them low for an extended period. Officials next meet on January 26-27 to plot the course for monetary policy.

Price rises in December slowed as gasoline costs increased 0.2 percent, the smallest gain in five months, after surging 6.4 percent in November. Food costs increased 0.2 percent last month after gaining 0.1 percent in November.

For the 12 months to December, prices rose 2.7 percent, the largest gain since 2007, after gaining 0.1 percent in 2008.

Stripping out volatile energy and food prices, the closely watched core measure of consumer inflation edged up 0.1 percent in December after being flat the prior month.

Core prices were lifted by rising prices for used cars and trucks, but shelter costs were flat and prices for new vehicles fell. High vacancy rates are keeping rentals depressed.

While the December consumer inflation report pointed to mute price pressures, the Reuters/University of Michigan Surveys of Consumers indicated consumers have started to worry about future inflation.

The survey's 1-year inflation expectations median rose to 2.8 percent from 2.5 percent in December.

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(Additional reporting by Emily Kaiser in Washington and Richard Leong in New York; Editing by Leslie Adler)

Pennsylvania BNP Paribas Inflation