By Lucia Mutikani
WASHINGTON (Reuters) - A jump in the cost of gasoline pushed U.S. consumer prices up in August at the fastest pace in more than three years and squeezed spending on other items, threatening to further slow the already sluggish economy.
At the same time, production at the nation's factories, mines and utilities dropped by 1.2 percent, the biggest decline since March 2009, other data on Friday showed.
The sour mix of numbers was tempered by an unexpected increase in consumer sentiment in early September and signs underlying inflation pressures remained contained.
Economists said the reports helped justify the Federal Reserve's decision on Thursday to launch a third round of bond purchases to try to lower borrowing costs and spur growth.
"It's very clear the economy is soft and it doesn't look like there is any real underlying inflation pressures the Fed needs to worry about, so they are going to keep their foot on the gas for a long time," said Jeremy Lawson, a senior economist at BNP Paribas in New York.
The Consumer Price Index increased 0.6 percent last month, the first increase in five months and the biggest gain since June 2009, the Labor Department said.
Gasoline prices, which also recorded their largest increase since June 2009, accounted for about 80 percent of the rise.
With gasoline costs increasing, service station chalked up healthy receipts. A second report from the Commerce Department showed sales at gasoline stations shot up 5.5 percent last month, helping to push overall retail sales up 0.9 percent.
It was the biggest gain in retail sales since February.
Sales of automobiles and building and garden equipment were also strong, but sales elsewhere were weak. A gauge that tracks the consumer spending component of the government's GDP measure actually fell 0.1 percent.
That and the strong CPI number left most economists anticipating modest GDP growth in the third quarter after output increased at an annual pace of 1.7 percent in the April-June period, well below the 2.5 percent rate that is needed to keep unemployment steady.
"For overall GDP in third quarter, we now see some modest downside risk to our current call for a 1.5 percent growth rate," said Michael Feroli, an economist at JPMorgan in New York.
Investors largely ignored the data as they continued to place bets based on the Fed's action on Thursday. Stocks on Wall Street rose, prices for U.S. government debt dropped and the dollar slumped as investors scurried to higher-yielding assets.
BROAD PRICE PRESSURES CONTAINED
While the CPI rose sharply, the so-called core index, which strips out volatile and food and energy costs, edged up just 0.1 percent for a second straight month.
In the 12 months through, August overall consumer prices increased 1.7 percent, staying below the Fed's 2 percent target, but advancing from July's 1.4 percent rise.
Food costs rose only marginally in August, but they are expected to rise significantly later this year as the impact of a severe drought, which has caused a spike in corn and soybean prices, works its way through to the supermarket.
Although gasoline pulled spending away from some categories in August, sales of automobiles rose by the most in six months, offering a silver lining.
"Vehicle sales are picking up. If that continues, and there is no reason to think it will not, output and hiring will improve and that could help turnaround the faltering manufacturing sector," said Joel Naroff, chief economist at Naroff Economic Advisors in Holland, Pennsylvania.
Autos have boosted factory activity, but manufacturers may need to scale back soon as data on business inventories showed stocks of unsold vehicles piling up in July.
A plunge in auto production contributed to the drop in industrial output in August, although Hurricane Isaac, which disrupted oil refineries in the Gulf Coast was also a factor.
"Even though an unwinding of these special factors will likely buoy industrial production in September, we do not look for much improvement in underlying manufacturing production trends at this point," said John Ryding, chief economist at RDQ Economics in New York.
(Editing by Andrea Ricci and Tim Ahmann)