By Lucia Mutikani

WASHINGTON (Reuters) - Consumer prices were flat in July for a second straight month and the year-over-year increase was the smallest in more than 1-1/2 years, giving the Federal Reserve room to ease policy further to tackle high unemployment.

Other reports on Wednesday showed home-builder sentiment in August hit its highest level in more than five years, while industrial production rose in July. However, a gauge of manufacturing in New York state contracted this month.

The tame inflation reading leaves the door open to more monetary stimulus from the U.S. central bank, even though data on job growth and retail sales have hinted at a bit of a pick-up in economic activity early in the third quarter.

Economists say growth is still too weak to do much to lower the nation's uncomfortably high 8.3 percent unemployment rate.

"The bigger worry is high unemployment," said Ryan Sweet, a senior economist at Moody's Analytics in West Chester Pennsylvania. "Additional monetary easing is likely, but they are probably going to wait until later this year, possibly after the election" in November.

The flat Consumer Price Index reading confounded economists' expectations for a 0.2 percent gain.

In the 12 months to July, the CPI rose 1.4 percent, the smallest gain since November 2010 and down from June's 1.7 percent increase, the Labor Department said.

The core CPI, which strips out food and energy, gained 0.1 percent from June. That was the smallest rise since February and it broke four straight months of 0.2 percent increases.

In the year to July, the core index, which is closely watched by the Fed, rose 2.1 percent - the smallest rise in nearly a year.

INDUSTRIAL PRODUCTION RISES

A second report showed industrial production increased 0.6 percent in July after a 0.1 percent gain in June, offering more hope the economy was improving after growth slowed in the second quarter.

The gain in industrial output, combined with surprisingly strong retail sales and a pick up in job growth in July, led some economists to argue the Fed's policy-setting Federal Open Market Committee probably does not need to launch a third round of bond purchases this year.

"If the FOMC is waiting to see if recent weak data were anomalous, this month's round of numbers seems to make the case that it might be, which in turn is enough to keep the Fed on the fence," said Chris Low, chief economist at FTN Financial in New York.

Officials at the Fed meet on September 12-13. Fed Chairman Ben Bernanke's speech at the central bank's high-profile gathering in Jackson Hole, Wyoming, in late August could offer clues on the near-term course of monetary policy.

Bernanke used that forum in 2010 to communicate the Fed's intention to pursue a second round of so-called quantitative easing.

The economy has been hit by fears of sharp cuts in government spending and tax increases in January. A debt crisis in Europe, which has left the euro area economy with one foot in a double-dip recession, has also eroded sentiment.

Staples Inc reported lower-than-expected quarterly results on weak demand in North America, Europe and Australia, prompting the largest U.S. office supply chain to cut its profit and sales forecasts for the year.

Current expectations for the year assume slower growth in the U.S. and continued weakness in Europe, Staples said.

UTILITIES, MINES AND FACTORIES BOOST OUTPUT

Industrial output last month was boosted by big gains in utilities production and mining.

While manufacturing was up 0.5 percent after a similar rise in June, automaking accounted for the bulk of the increase. But with auto sales softening against the backdrop of weak income growth and high unemployment, manufacturers could be forced to scale back production.

Average weekly earnings were flat in July, when adjusted for inflation, and were up only 0.6 percent from a year ago.

A third report from the New York Federal Reserve Bank showed factory activity in New York state contracted in August for the first time since October 2011.

"There are signs that manufacturing activity will continue to weaken ahead," said Daniel Silver, an economist at JPMorgan in New York.

"Auto production schedules point to a drop off in production in August and most of the manufacturing surveys have deteriorated in recent months. And exports look due to come off because of struggles with growth abroad."

Last month, inflation was held down by a 0.3 percent drop in energy prices, which offset a 0.1 percent gain in food prices.

A drought ravaging much of the country could lift food prices in the coming months, but the impact on inflation should be modest since food accounts for only about 14 percent of the CPI.

(Additional reporting by Alister Bull; Editing by Neil Stempleman and Tim Ahmann)