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.
The percentage decline 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.
It's (housing) going to be slight drag on the economy during the summer building months. Forecasters are coming to the realization that growth will be slower in the second half, said Mark Vitner, a senior economist at Wells Fargo Securities in Charlotte, North Carolina.
Separately, price paid at the farm and factory gate fell 0.3 percent last month as gasoline costs tumbled, after falling 0.1 percent in April. That compared to analysts' expectations for a 0.5 percent drop.
U.S. stock index futures extended losses after the housing data, while Treasury debt prices rose . The U.S. dollar fell against the yen.
Housing starts rose in March and April as new home construction was pushed forward to take advantage of a government tax credit for home buyers. Buyers had to sign contracts by April 30 to qualify for the tax credit.
In the wake of the end the tax credit, home builder sentiment fell sharply in June. Analysts, however, believe the pullback in housing will be temporary, citing the gradual improvement in the economy. Demand for loans to buy homes rebounded from 13-year lows last week.
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, also giving the economy a boost.
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.
Although the economy has grown for three straight quarters, it has lacked vigor. Anxiety over the recovery pace has eroded President Barack Obama's popularity and could cost the Democratic Party dearly in the November congressional elections.
Groundbreaking for single-family homes tumbled 17.2 percent to an annual rate of 468,000 units in May after a 5.6 percent increase in April.
The percentage decline in May was the largest since January 1991 and snapped four months of gains. However, starts for the volatile multifamily segment surged 33 percent to a 125,000-unit annual pace.
Home completions fell 7.4 percent to a 687,000-unit pace. The inventory of total houses under construction fell 2.3 percent to a record low 475,000 units in May, while the total number of units authorized but not yet started dropped 4 percent to 91,200 units, the lowest since November.
(Reporting by Lucia Mutikani; Additional reporting by Pedro Nicolaci da Costa in Washington and Richard Leong in New York; Editing by Andrea Ricci)