By Lucia Mutikani

WASHINGTON (Reuters) - Sales at U.S. retailers dropped a steep 2.7 percent in December, government data showed on Wednesday, as a deteriorating economy forced consumers to cut back on spending during the key holiday period.

The dour data suggested the economy shrank even more sharply than had been thought in the fourth quarter, setting the stage for another big drop at the start of 2009 and raising chances the more than year-old U.S. recession will be the longest since the Great Depression.

"The U.S. consumer is reeling ... the weakness in spending will likely continue through 2009 as households tighten their belts further," said Benjamin Reitzes, an economist at BMO Capital Markets in Toronto.

The Commerce Department said December's decline, the largest since October and more than twice what Wall Street economists had expected, took sales 9.8 percent below their year-ago level, the biggest drop on records dating to 1993.

Analysts said the decline in the dollar volume of sales was partly due to fast-falling gasoline prices and deep price discounts offered by retailers in a bid to lure buyers, but still signaled widespread weakness.

The data helped knock U.S. stocks to six-week lows, with the Dow Jones industrial average falling 248.42 points, lending a safe-haven bid to U.S. government debt.

Falling household wealth, rising unemployment, tight credit conditions and a murky economic picture have forced consumers to cut back sharply on spending, which accounts for about two thirds of U.S. economic activity.

"The economy is in free fall, and Washington has not done enough to pull out the parachute," said Bernard Baumohl, chief global economist at the Economic Outlook Group in Princeton, New Jersey. "Consumers ... have simply shut down spending and shifted into survival mode."

U.S. President-elect Barack Obama and Congress are working on a package of spending and tax-cut measures to spur activity, and analysts said the data illustrated the need for a massive fiscal injection to jump-start the ailing economy.

BANKRUPTCY FILINGS MAY RISE

Analysts said plunging retail sales could result in more business failures. On Wednesday, Nortel Networks Corp, North America's biggest telephone equipment maker, filed for bankruptcy.

Other bankruptcy filings included regional department store chain Gottschalks Inc and apparel chain Goody's LLC, which said it would liquidate its remaining stores.

Underscoring the grim outlook, a separate report showed sales at wholesalers, retailers and factories fell a record 5.1 percent in November. Despite the drop, businesses managed to cut inventories by 0.7 percent, suggesting a sharp pullback in production.

Separately, the Federal Reserve said the economy continued to weaken early in the new year.

The report on retail sales showed gasoline receipts tumbled 15.9 percent after diving by a record 18.3 percent in November, reflecting a plunge in the cost of oil from record highs.

Sales of new cars and parts fell 0.7 percent, a fourth straight monthly decline. Lack of access to credit and mounting job losses have undercut new car sales over the past months.

But even excluding the weakness in auto and gasoline sales, sales fell 1.5 percent in December, the biggest drop since September 2001, when U.S. consumers retreated in shock after the attacks on the World Trade Center and Pentagon.

The Federal Reserve lowered benchmark interest rates close to zero in December and has flooded financial markets with cash, efforts that have had some success in lowering mortgage rates.

The Mortgage Bankers Association said mortgage applications rose last week, spurred by a surge in refinancing, but an index measuring loans to buy homes fell 14.1 percent.

Highlighting the global economy's weakness, U.S. import prices dropped 4.2 percent in December after falling 7 percent the previous month, a Labor Department report showed, as costs for oil and many nonpetroleum products tumbled. Import prices have dropped for five straight months.

(Additional reporting by Doug Palmer in Washington, Brad Dorfman in Chicago, and Julie Haviv in New York; Editing by Leslie Adler)