* U.S. CPI falls 0.7 pct in Dec, 3rd straight monthly drop
* U.S. core CPI unchanged in Dec vs Nov, up 1.8 pct on year
* Industrial production slides 2 pct in Dec
* Net capital inflows to U.S. fall in Nov
By Lucia Mutikani
WASHINGTON, Jan 16 (Reuters) - U.S. inflation slowed to a half-century low last year and industrial output dropped for the first time since 2002 as the recession deepened toward year-end, raising the specter of deflation.
The U.S. Labor Department said on Friday the Consumer Price Index dropped a sharp 0.7 percent in December, a third straight decline that capped a year in which prices advanced only 0.1 percent, the weakest 12-month reading since December 1954.
Weakening activity worldwide has taken the floor out from under commodity prices, pulling headline inflation down sharply. However, core U.S. inflation, which strips out volatile food and energy costs, is also slowing, raising the risk of deflation.
"If the economy's a little bit weaker than we expect, deflation is a possibility, especially given it's not just us, it's the whole world," said David Wyss, chief economist, Standard & Poor's in New York.
The dollar briefly extended losses versus the euro after the reported a sharp decline in net capital inflows, while U.S. Treasury debt prices traded steady at sharply lower levels.
The announcement of more U.S. government aid to Bank of America overnight helped the U.S. stock market to open higher despite the troubling data.
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.
With consumers retrenching, U.S. industries are cutting back sharply.
The Federal Reserve said on Friday that U.S. industrial production dropped 2 percent last month, capping a dismal year for manufacturing as the recession took hold. For the fourth quarter, industrial output fell at an 11.5 percent annual rate.
Compared with December 2007, industrial production was down 7.8 percent, the biggest 12-month drop since September 1975.
AGGRESSIVE ACTION
The Fed has dropped benchmark interest rates virtually to zero and with little firepower left on that front, is concentrating on pumping money into troubled credit markets to try to restore lending, hoping to spur activity and beat back incipient deflation risks.
Core prices, which exclude food and energy items, were flat for the second month in a row in December. On a year-over-year basis, core inflation rose 1.8 percent, the smallest increase since December 2003 and still within a range Fed officials would be comfortable with.
"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," Wyss said.
Energy prices fell 8.3 percent in December, after declining 17 percent the prior month. Compared to the same period last year, energy prices were down 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 Emily Kaiser in Washington and Ryan Vlastelica in New York; writing by Lucia Mutikani and Tim Ahmann; Editing by Neil Stempleman)