(Adds details, market reaction)
By Lucia Mutikani
WASHINGTON, Jan 16 (Reuters) - U.S. consumer prices fell sharply for a third straight month in December, closing out a year in which a sagging economy pulled inflation down to a half-century low, raising the specter of a troubling deflation.
The Labor Department said on Friday the annual pace of price increases in December was the slowest in more than 50 years.
The closely watched Consumer Price Index dropped 0.7 percent after falling 1.7 percent in November -- tumbling for a third straight month -- but slightly less than analysts' forecast for a a drop of 0.9 percent in December.
On a year-over-year basis, consumer prices rose 0.1 percent, braking sharply from a 1.1 percent increase the prior month. It was the weakest reading since CPI fell 0.7 percent in December 1954
"We're probably a little concerned about deflation, but it's too early to worry about that based on this data," said Steve Goldman, market strategist at Weeden & Co in New York.
U.S. equity index futures held gains after the data, while government bond prices extended losses.
Fears of deflation appeared to get traction after data on Thursday showed U.S. producer prices fell for the fifth consecutive month in December.
Mounting job losses, falling household wealth and tight credit conditions have forced consumers to hold back on spending, limiting businesses' ability to raise prices and encouraging some to offer heavy discounts to lure customers.
The inflation data is probably good news for the Federal Reserve, which last month cut its key lending rate to virtually zero, and has grown its balance sheet to over $2 trillion in actions aimed at pulling the economy out of a year-long recession.
Core prices, which exclude food and energy items, were flat for the second month in a row in December. That compared to analysts' prediction for a 0.1 percent increase.
On a year-over-year basis, core CPI rose 1.8 percent, slowing from a 2.0 percent increase in November and the smallest increase since a 1.1 percent rise in December 2003.
"Low inflation is good, deflation is bad. If you can keep that core rate in the 1 percent to 2 percent range, that's where the Fed wants it," said David Wyss, chief economist at Standard and Poor's in New York.
Energy prices fell 8.3 percent in December, after declining 17 percent the prior month. Compared to the same period last year, energy prices fell a record 21.3 percent.
Within energy, the gasoline index fell 17.2 percent and accounted for almost 90 percent of the decrease in headline CPI, the Labor Department said.
Sharply slowing global growth has dampened demand for oil, driving down the price from a record peak of $147 a barrel touched last July. (Additional reporting by Ryan Vlastelica in New York, Editing by Andrea Ricci)