Consumer prices held steady as the credit crisis took a toll on the sluggish U.S. economy and dampened inflation. The Labor Department announced yesterday (Thursday) that the Consumer Price Index (CPI) was unchanged in September after declining 0.1% in the prior month.

Year-over-year, consumer prices increased 4.9% for the 12 months ended September 2008, down from a 5.4% increase in August.

Oil prices made up the bulk of the decline in consumer prices as the cost of crude has dropped by over half from its record high of $147 per barrel in July.

So-called core CPI, which excludes volatile food and energy prices, increased 2.5% year-over-year in September, the same rate as the previous month.

“The credit crunch is intensifying, and enough damage has been done to ensure the next couple of quarters will be much weaker,” James O’Sullivan, a senior economist at UBS Securities LLC in Stamford, Conn., told Bloomberg News. “The pendulum has swung sharply to the downside risks to growth rather than inflation.”

In a separate report, the Federal Reserve Bank of Philadelphia yesterday announced that its general economic index had a drastic decline to –37.5 from 3.8 in September. A negative reading indicates a contraction in economic growth.

Production at U.S. factories was down 2.8% in September due, in part, to factory closures from hurricanes Gustav and Ike, as well as a protracted strike at aerospace firm The Boeing Co. (BA).

“The data suggests the U.S. economy is mired in recession and things are getting worse rather than better,” Sal Guatieri, an economist for BMO Capital Markets in Toronto, told Reuters.

Earlier this week, the government announced that the Producer Price Index (PPI) fell 0.4%. PPI measures the wholesale prices manufacturers pay for materials to produce finished goods.

Declines in both wholesale and consumer prices could give U.S. Federal Reserve Chairman Ben S. Bernanke and the other members of the Federal Open Market Committee more incentive to lower interest rates at their next monetary policy meeting slated for Oct. 28 – 29.

The Fed lowered its target rate to 1.5% from 2.0% at an unscheduled meeting on Oct. 8 after the stock market suffered historic losses at the onset of the month.

Source: Inflation Cools as Economic Downturn Deepens