U.S. consumer sentiment dropped more than expected in early August, registering its lowest reading since the aftermath of Hurricane Katrina, a report showed on Friday, as inflation expectations rose.

The University of Michigan's preliminary reading of consumer sentiment in August was 78.7, down from July's final reading of 84.7, said sources who saw the subscription-only report. The median forecast of Wall Street economists polled by Reuters was 83.6.

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U.S. stocks fell while government debt prices rose after the data. The dollar fell against the euro and the yen.

"It's a very stagflationary kind of result," said Peter Kretzmer, senior economist at Banc of America Securities LLC in New York. "This is a larger downward move than what we've seen even though gasoline prices haven't moved that much higher in the month of August."

The survey's index of current conditions fell to 100.8 from 103.5 in July while consumer expectations slid to 64.5 from 72.5.

Consumer spending accounts for about two-thirds of U.S. economic activity, but in recent years confidence measures have been a weak guide to actual spending.

U.S. interest rate futures briefly reduced chances for a September interest rate hike by the Federal Reserve following the release, but climbed back to a perceived 18 percent chance after investors digested the data, which showed that consumers had increased their expectations for inflation.

The University of Michigan's preliminary August reading on one-year U.S. inflation expectations was 4.2 percent, up from 3.2 percent in July. Median expectations for inflation over a five-year horizon increased to 3.1 percent from 2.9 percent.

"Inflation expectations in the Michigan survey jump a full percentage point ... This is potentially alarming for Fed policy," said Brian Dolan, director of research at Forex.com in New Jersey."

The Fed has repeatedly cited contained inflation expectations as one of the bases on which it expects inflation pressures to moderate.

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