Housing starts fell to a five-month low in May but industrial output rose, evidence of an uneven recovery that has kept inflation at a minimum.

As the government's tax incentives for homebuyers expired, new home building dropped 10 percent to a seasonally adjusted annual rate of 593,000 units, the lowest level since December, the Commerce Department said on Wednesday.

Industrial production, in contrast, surged 1.2 percent. Some of the rise was due to a spike in utilities as rising temperatures prompted many Americans to turn on their air conditioners. But manufacturing output was firm as well, climbing 0.9 percent, according to the Federal Reserve report.

Despite that performance, prices at the wholesale level retreated in May. The Labor Department's Producer Price Index eased 0.3 percent as gasoline costs tumbled.

The grim housing picture is a concern for economists. Real estate was at the epicenter of the credit crisis, and many believe construction must play a role in any robust recovery.

These numbers are not good, said Dan Cook, senior market analyst at IG Markets in Chicago. There's too much (housing) inventory, and it's going to take a while for the industry to work its way through that.

That should contribute to a moderation of the U.S. economic recovery in coming months.

Growth will be slower in the second half of the year, said Mark Vitner, a senior economist at Wells Fargo Securities in Charlotte, North Carolina.

U.S. stocks were slightly lower after the data, while Treasury debt prices rose.

The percentage decline in home construction was the biggest in 14 months and April's housing starts were revised down to show a 3.9 percent increase from a previously reported 5.8 percent rise. Analysts polled by Reuters had expected housing starts to fall to 650,000 units. Compared to May last year, starts were up 7.8 percent.

New building permits, which give a sense of future home construction, dropped 5.9 percent to a 574,000-unit pace in May, the lowest in a year. That followed a 10.9 percent drop in April and compared to analysts' forecasts for a rise to 630,000 units.

WHAT INFLATION?

The recovery from the worst recession since the 1930s appeared to have lost some momentum in May, with private hiring slowing sharply and retail sales falling. However, employers increased working hours and core retail sales rose last month, offering some hope.

The combination of low inflation and still low levels of resource utilization should allow the Federal Reserve to renew its commitment to low interest rates at next week's meeting, which would help to nurture the recovery.

Core producer prices, which exclude food and energy, rose just 1.3 percent in the year to May, slightly above forecasts but still near the bottom of the Fed's presumed comfort range.

Fed data showed a 1 percentage point rise in capacity use to 74.7 percent for May. That was the highest since October 2008, but still 5.9 points below its average from 1972 to 2009.

The Fed has historically not tightened before cap u (capacity use) is at or near 78 and usually nearer to 80, said Alan Ruskin, head of currency strategy at RBS. That still suggests that even with manufacturing leading the recovery, this indicator is some way away from flashing red to the Fed that they must tighten.

(Reporting by Lucia Mutikani; Additional reporting by Pedro Nicolaci da Costa and Emily Kaiser in Washington and Richard Leong in New York; Editing by Andrea Ricci)

Inflation