(Reuters) - The worst drought in a quarter century will slash corn yields across the U.S. Midwest by much more than most analysts had expected, the government said on Wednesday in a report that reignited a 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.

As a result, USDA reduced its forecast for corn ending stocks by 37 percent from last month, partly offset by lower exports and less ethanol usage.

The surprisingly deep cut to the yield outlook jolted traders, who had expected the USDA to take a more conservative approach to adjusting its outlook. The reduction in ending stocks was deeper than the 32 percent cut expected by analysts.

Corn on the Chicago Board of Trade soared after the release of the report, with the December contract initially surged by 23 cents and settling to a 15-cent, or 2 percent, gain at $7.76 a bushel gain at mid-morning. Prices have risen 34 percent in the past four weeks.

Soybean futures were up 1.6 percent at $16.73 a bushel, and wheat was up 1.8 percent at $8.19-1/2 a bushel.

Shawn McCambridge, analyst at Jefferies Bache, said the startlingly large cut "tells me they feel pretty confident this crop has been hurt in a big way." Additional cuts are likely, he added, when USDA makes spot checks of fields as it prepares for the August 10 report that makes the first estimate of the harvest.

The 12 percent cut in the yield forecast was the largest in memory, said the chairman of USDA's World Agriculture Outlook Board, who could not immediately find a comparable cut. Wheat and soybean stocks were also below expectations, with soybean yields also pared due to the drought.

"They sent a signal of, 'Listen, we got a serious problem here,' and so they took the yield down substantially," said Don Roose, an analyst with U.S. Commodities.

A mild and early planting season raised hopes of a record corn crop. But the drought changed prospects dramatically. Based on current conditions, USDA projected a harvest of 12.97 billion bushels, 12 percent less than a month ago, but still the third largest on record.

It would bring the third year in a row of tight corn supplies. USDA 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, meaning less meat per person this year and next. Per capita meat consumption would drop by 1 percent, to 200.6 lbs in 2013 because of smaller supplies and higher prices.

Other foods 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, a reflection of smaller global supplies due to the downturn in the United States, the world's largest grower and exporter.

Along with corn, USDA's forecasts of wheat and soybean ending stocks for the 2012/13 marketing year were lower than traders expected. USDA estimated carryover stocks of 664 million bushels of wheat and 130 million bushels of soybeans, compared to 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 wilted. Forty percent is rated good or excellent, down 20 points in a month. It was the lowest rating for corn in early July since the 1988 drought, which also hit early in the growing season.