* U.S. consumer prices fall unexpectedly in March
* Prices post first 12-month drop since 1955
* Industrial output declines sharply in March
* New York state manufacturing contracts less severely (Adds industrial output, updates markets)
By Lucia Mutikani
WASHINGTON, April 15 (Reuters) - U.S. consumer prices fell in March, posting their first 12-month drop in nearly 54 years, and industrial production slipped further, according to data on Wednesday that underscored the severity of the recession.
The Labor Department said its closely watched Consumer Price Index fell 0.1 percent, after increasing 0.4 percent in February. On a year-over-year basis, consumer prices dived 0.4 percent, the first 12-month decline since August 1955, as slumping demand took the floor out from under energy prices.
"The numbers speak to an economy that is in deep recession, but we're no longer in the shock mode of staggering numbers that speak to a serious slide lower in terms of macroeconomic activity, coupled with the threat of inflation," said Peter Kenny, managing director at Knight Equity Markets in Jersey City, New Jersey.
In a separate report, the Federal Reserve said output at the nation's factories, mines and refineries dropped 1.5 percent in March, capping a brutal quarter as businesses pared orders and cut inventory.
U.S government bond prices edged higher on the data, but
stocks on Wall Street were mixed after Wal-Mart Stores Inc
Analysts reckon that declining domestic output and mounting unemployment will limit price increases throughout 2009.
Energy prices dropped 3 percent in March after rising 3.3 percent the previous month. The food index eased 0.1 percent for a second straight month in March, the department said.
NO DEFLATION THREAT
While the inflation data came on the heels of a report on Tuesday showing U.S. producer prices fell 1.2 percent in March, there was no threat of deflation just yet, analysts said, pointing to core prices, which have risen for three straight months.
Core prices, which exclude food and energy, rose 0.2 percent. Core prices have risen 0.2 percent for three months in a row.
"This suggests that deflation is not a concern for the U.S. economy despite the worst recession in decades," said Harm Bandholz, an economist at Unicredit Markets & Investment Banking in New York.
Deflation is a broad-based decline in prices that can undercut an economy by leading consumers to hold off purchases in the hopes of even lower prices.
March core prices were lifted by increased costs for tobacco, which accounted for over 60 percent of the rise. New vehicle price increases also contributed to the rise in underlying inflation.
Core prices rose 1.8 percent from a year ago.
A separate factory report from the New York Federal Reserve Bank showed manufacturing activity in New York State contracted less severely in April after diving to a record low the previous month.
Despite, the steep decline in industrial production in March, this was consistent with views that the pace of deterioration in the economy was slowing and the recession should end in the second half of the year.
"Businesses reacted swiftly to last year's plunge in demand and production levels have been adjusted sufficiently to the new, lower levels of demand," said Tony Crescenzi, chief bond analyst at Miller Tabak & Co in New York.
"In other words, production needn't be cut much more and might actually increase in certain industries unless there is another plunge in demand."
The New York Fed's "Empire State" general business conditions index was minus 14.65 in April, compared with record low of minus 38.23 in March.
Separately, net capital outflows from the United States slowed in February from a record outflow the previous month, boosted by buying in U.S. Treasury, agency, and corporate bonds, Treasury Department data showed. [ID:nN15491866] (Additional reporting by Emily Kaiser in Washington; Richard Leong and Ryan Vlastelica in New York; Editing by Neil Stempleman)