Prices were also up sharply for health care, housing and education. However, these gains were offset somewhat by falling prices for clothing, new cars and computers.
Workers' wages failed to keep up with the higher inflation. Average weekly earnings, after adjusting for inflation, dropped by 0.9 percent in 2007, the fourth decline in the past five years. The lagging wage gains are cited as a chief reason many workers have growing anxiety about their economic futures.
Core inflation, which excludes both energy and food, rose 2.4 percent last year, slightly lower than the 2.6 percent increase of 2006. It is the performance of core inflation that the Fed closely monitors.
Analysts said the slight drop in core inflation for 2007 plus various reports showing the economy is in the grips of a serious slowdown will convince the central bank that a key interest rate it controls should be reduced by a bold half-point when Fed officials next meet on Jan. 30-31.
"Price pressures may be a little greater than the Fed would like but with the economy hitting the skids, inflation is not so high to stand in the way of aggressive action," predicted Joel Naroff, chief economist at Naroff Economic Advisers.
On Wall Street, investors staggered through another volatile session, with the Dow Jones industrial average falling 34.95 points to close at 12,466.16. The loss, which reflected concerns about spreading economic weakness, followed a huge 277.04 point drop in the Dow on Tuesday after banking giant Citigroup posted a $10 billion fourth quarter loss, reflecting the meltdown in the subprime mortgage market.
Providing further evidence of a slowing economy, the Fed reported Wednesday that output at the nation's factories was flat in December, the worst showing since an outright decline of 0.5 percent in October. Economists said that poor reading confirmed their view that the manufacturing sector has slipped into a recession.
In a separate report, the Fed said its latest survey of economic conditions around the country showed the economy was losing momentum heading into 2008 although seven of the 12 Fed regions did report slight increases in activity.
The mounting signs of economic weakness have greatly raised concerns that the economy could be slipping into a recession. Unemployment jumped from 4.7 percent in November to 5 percent in December, the biggest one-month increase since the aftermath of the 2001 terrorist attacks. Many of the nation's biggest financial institutions have been reporting billions of dollars in losses, reflecting the meltdown in the subprime mortgage market that was triggered by a two-year long slump in housing.
The December weakness in industrial production reflected flat output at U.S. factories. For the year, output at auto plants fell by 4.1 percent as Detroit continues to struggle with falling demand in the face of soaring gasoline prices. Industries connected to the troubled housing sector including wood products and furniture also suffered big declines for the year.
"We believe that today's report confirms that manufacturing is in a recession," said Daniel Meckstroth, chief economist for the Manufacturers Alliance/MAPI. "General growth in exports and a few bright spots in aerospace, high tech and medical equipment cannot mitigate weak consumer spending and increasingly slow and cautious business investment activity."
For December, the Consumer Price Index rose by 0.3 percent, slower than the 0.8 percent jump in November, as food costs were flat for the month and energy prices rose by 0.9 percent after an even bigger 5.7 percent jump in November. Outside of food and energy, core inflation rose a more moderate 0.2 percent in December.
The rising risk of a recession has prompted politicians to consider stimulus packages to give the economy a jump-start to either prevent a recession or at least mitigate its fallout. President Bush has said he may unveil a plan around his Jan. 28 State of the Union address. Democrats in Congress and presidential candidates in both parties are putting forward their own plans.
The 4.1 percent increase in overall prices last year was the biggest since a 6.1 percent jump in prices in 1990.
Overall energy costs rose by 17.4 percent this past year while food costs rose by 4.9 percent. Both were the biggest increases since 1990. Gasoline prices were up 29.6 percent, the biggest increase since they soared by 30.1 percent in 1999.
By Martin Crutsinger, AP Economics Writer