WRAPUP 3-U.S. consumer prices confirm inflation in check

* U.S. consumer prices edge up in May from April

* Prices post largest 12-month drop since 1950

* Q1 current account deficit smallest since Q4 2001 (Adds details, updates with market closings in paragraphs 9 and 10)

By Lucia Mutikani

WASHINGTON, June 17 (Reuters) - U.S. consumer prices rose slightly in May, but over the past 12 months prices registered the biggest drop in nearly 60 years, allaying fears that inflation could threaten prospects for economic recovery.

The Labor Department said on Wednesday higher gasoline prices contributed to the smaller-than-expected 0.1 percent rise in May's Consumer Price Index from April when the CPI was unchanged from the previous month. Financial markets had expected a 0.3 percent increase in May.

Compared to the same period last year, the CPI fell 1.3 percent, the largest decline since April 1950. The pace of the price decline also accelerated -- the CPI dropped 0.7 percent year-on-year in April.

The data soothed worries that massive spending by the U.S. government and the Federal Reserve to pull the economy out of an 18-month-long recession -- the longest since the Great Depression -- may end up fueling inflation.

The U.S. central bank has been aggressive to ward off the risk of a disabling deflation and might not feel it is fully out of the woods yet.

"There is no sign that there has been widespread inflation because of the Fed's quantitative easing regime. In fact, long-term inflation expectations haven't budged and the Fed is still ahead of curve on inflation," said John Canally, an economist at LPL Financial in Boston.

FED MAY SCALE BACK TREASURY PURCHASES

Analysts reckon the Fed could play down the market's inflation expectations at its policy meeting next week and signal some scaling back on its purchases of U.S. Treasuries. It has held overnight rates near zero since December.

"They may signal that they are going to pull back from more aggressive quantitative easing. The deficit we need to finance is so out of control," said Howard Simons, a strategist at Bianco Research in Chicago.

U.S. government bond prices initially rose on the data as traders trimmed bets the Fed could be forced to bump up interest rates by year end, but bonds stumbled as a five-day rally ran out of steam.

Stocks on Wall Street ended mixed .DJI, with the benign inflation report overshadowed by a gloomy forecast from package delivery company FedEx Corp (FDX.N), which some view as a bellwether for the broader economy.

A separate report from the Commerce Department showed the deficit in the U.S. current account, the broadest measure of the United States' international trade, shrank in the first quarter to $101.5 billion, the smallest gap since the fourth quarter of 2001. For related news click [ID:nN17329437]>.