The worst Midwest drought in a quarter century is doing more damage to U.S. crops than widely believed, already shrinking corn yields to the lowest in nearly a decade, the government said on Wednesday.

In a report that reignited a near-record rally in grain prices, the U.S. Department of Agriculture said the crop will average just 146.0 bushels an acre, down 20 bushels from its June estimate and lower than analysts' estimates just a week ago. One official said it was the biggest such cut he could recall.

The dramatic scaling back of what had initially been forecast to be a record harvest has sent corn and soybean prices up by more than a third over the past month, as extreme heat and dry conditions stunt corn growth in the world's largest grower and exporter.

Corn prices raced more than 3 percent higher and soybeans were close to a record high on Wednesday before profit taking and forecasts for slightly wetter weather curtailed gains. Prices are still up more than a third over the past month as the drought threatens to set off another year of food price inflation and supply concerns.

The USDA cut its corn harvest projection to 12.97 billion bushels for 2012/13 - still the third largest on record. The yield would be the lowest since 2003, although still far higher than the 85 bushels an acre following the drought of 1988. The surprisingly deep cuts to the supply outlook jolted traders, who had expected the USDA to be more conservative in adjusting its views. The chairman of World Agriculture Outlook Board said the 12 percent cut was the largest he could recall.

"They sent a signal of, 'Listen, we got a serious problem here'," said Don Roose, an analyst with U.S. Commodities.

As a result, USDA reduced its forecast for corn ending stocks - the amount of grain still in bins at the end of next summer, before the new harvest - by 37 percent from last month, more than the 32-percent reduction expected.

At 1.183 billion bushels, U.S. corn stockpiles will still rise by nearly a third from this year's ultra-low levels, with the reduced supply outlook partly offset by downward revisions to exports and ethanol usage as near-record prices curb consumption. Separate data showed ethanol output fell last week for the fourth time, reaching its lowest in two years.

Wheat and soybean stocks were also below expectations. Soybean yields were cut nearly 8 percent to 40.5 bushels per acre, the second lowest since 2003, due to the drought.

The USDA cut its forecast for global corn stocks by 14 percent, although inventories will still be the highest in three years.

By midday, December corn on the Chicago Board of Trade was down 0.9 percent at $7.11 a bushel, while November soybean futures rose 0.4 percent to $15.45 a bushel. Front-month wheat gained 0.7 percent to $8.10 a bushel.

The report "tells me they feel pretty confident this crop has been hurt in a big way," says Shawn McCambridge, analyst at Jefferies Bache. Additional cuts are likely, he said, when USDA makes spot checks of fields as it prepares for an Aug. 10 report which will make the first estimate of the harvest.

This would be the third year in a row of tight corn supplies. U SDA reduced by 100 million bushels, or 2 percent, its forecast of corn for ethanol. It also reduced export and livestock feed forecasts.

Higher feed prices will depress U.S. meat production and cut into margins for companies like Tyson and Smithfield . with per capita consumption would drop by 1 percent, to 200.6 lbs in 2013 because of smaller supplies and higher prices.

Other food prices could be affected as well. Corn, wheat and soybeans, the three most widely grown U.S. crops, are the raw ingredients in a panorama of foods from cereals and salad dressing to scones and cooking oil.

"The immediate view is that crop producers will bear the brunt of financial losses but losses in animal industries will be enormous in the coming year, perhaps becoming considerably greater than for the crop sector," said Chris Hurt, agricultural economist at Purdue University, pointing to high feed prices.

China was forecast to import 5 million tonnes of corn in the marketing year that opens on Sept 1, down 2 million tonnes from the USDA's June forecast as available U.S. supplies shrink.

The USDA also reduced its estimated carryover stocks of wheat to 664 million bushels and soybeans to 130 million bushels soybeans, compared with trade expectations of 718 million bushels of wheat and 141 million bushels of soybeans.

USDA cut its forecast of the wheat crop in Russia by 4 million tonnes due to poor yields, in Kazakhstan by 2 million tonnes because of hot and dry weather in June, and in China by 2 million tonnes due to lower yields.

Since mid-June, corn and soybean crop conditions have worsened. Just 40 percent of the corn crop is now rated good or excellent, down 20 points in a month. It was the lowest such rating for the time of year - early July - since the 1988 drought, which also impacted crops early in the growing season.

(Additional reporting by Russ Blinch; Editing by John Picinich and Bernadette Baum)