Inflation tame but credit fears spook markets

By Joanne Morrison

WASHINGTON (Reuters) - Falling gasoline costs held U.S. consumer prices nearly in check in July and industrial output rose, according to data on Wednesday that suggested the economy was on a sound footing despite financial markets' credit fears.

Other reports showed a slight dip in New York state manufacturing activity this month and a decline in the amount of capital flowing into the United States in June.

Analysts said the latest data, combined with reports earlier this week showing solid retail sales and a shrinking trade deficit, point to an economy that is performing relatively well.

"Things don't look that bad. There is no evidence yet in the data that the economy is on the cusp of losing steam," said Michael Darda, chief economist at MKM Partners in Greenwich, Connecticut.

Still, a gauge of home builder sentiment from the National Association of Home Builders hit its lowest ebb since January 1991, suggesting a housing slump still had a ways to run.

"Builders realize that issues related to mortgage credit cost and availability have become more acute, filtering some prospective buyers out of the market and prompting others to delay their decision to purchase a new home," said NAHB President Brian Catalde, a home builder from El Segundo, California.

The bulk of the data came in close to Wall Street expectations and financial markets focused less on indications of the economy's recent health and more on ongoing worries that credit would evaporate as U.S. subprime mortgage problems widen.

The blue-chip Dow Jones industrial average .DJI ended down 1.29 percent at 12,861.47 -- its first close below 13,000 since April 24 -- while the broader Standard & Poor's 500 Index .SPX fell 1.39 percent to end at 1,406.70.

The S&P, which has dropped more than 9 percent since hitting a record high on July 16, is now trading lower in the year-to-date.

Over the past week, central banks around the globe have pumped money into the financial system in an effort to keep credit flowing, but they have had only limited success calming nervous markets.

Financial markets now expect the U.S. Federal Reserve to lower interest rates at its next meeting on September 18, if not before, to buffer the economy as credit becomes more scare.

Many economists, however, do not expect the central bank to act that quickly.

"To me, the risk remains the economy not inflation, but I doubt the Fed will change course before the September 18th meeting without an even more major deterioration in financial conditions," said Joel Naroff, president and chief economist of Naroff Economic Advisors in Holland, Pennsylvania.

CONSUMER PRICES UP LESS THAN EXPECTED

The Consumer Price Index, a key inflation gauge, rose just 0.1 percent last month as gasoline prices fell 1.7 percent, the Labor Department said. Economists polled by Reuters had expected a rise of 0.2 percent.