U.S. housing starts rose to a six-month high in January and industrial output increased solidly, pointing to an economic recovery that was taking a firm hold and respectable first-quarter growth.

Groundbreaking activity for new homes increased 2.8 percent to an annual rate of 591,000 units, reversing the prior month's weather-induced drop, a report from the Commerce Department showed on Wednesday. That was above market expectations for a 580,000-unit pace.

In a separate report, the Federal Reserve said industrial production rose 0.9 percent, with manufacturing, mining and utilities all posting gains. Economists had expected a 0.7 percent increase.

The data is very solid and very strong ... the economy gets no respect but it is doing significantly better and we see that on the production side in particular, said Michael Strauss, chief economist at Commonfund in Wilton, Connecticut.

The reports and better-than-expected earnings from Deere & Co., the world's largest maker of agricultural equipment, gave a lift to U.S. stocks. The dollar also rose broadly, while prices for U.S. government debt moved lower.

Deere, seen as a bellwether for the global economy, raised its outlook for fiscal 2010 machinery sales growth to a range of 6 percent to 8 percent from a previous estimate that sales would fall 1 percent.

Economists and investors are watching for any sign the U.S. economy may be losing steam after a surprisingly strong finish to 2009. The signs of strength in the economy, which grew at a 5.7 percent rate in the fourth quarter, came as the recovery in the euro zone showed evidence of faltering.

President Barack Obama, whose administration deployed a $787 billion stimulus package last year to rescue the economy, on Wednesday said more work still needed to be done.

Our work is far from over but we have rescued this economy from the worst of this crisis, he said.

HOUSING BEING WATCHED

The housing market, the main trigger of the most painful U.S. economic downturn in 70 years, has been a particular area of concern after disappointing reports on December home sales.

Some analysts worry mortgage rates will rise, putting additional pressure on a still weak market, when the Fed ends purchases of mortgage-related securities at the end of next month.

The housing starts report, however, hinted at fundamental improvement. Over the past 12 months, housing starts have surged 21.1 percent, the largest increase since April 2004.

It's a positive surprise on all fronts and shows that overall demand has moved higher. That's an important element to watch as we move through a cycle going from incentive-based to more organic growth, said Craig Peckham, equity trading strategist at Jefferies & Co in New York.

Home construction last month was boosted by clear weather after a stormy December. That December weather had also played a role in industrial production, lifting output at utilities. January's report on industrial output showed broader gains.

Capacity utilization, a measure of slack in the economy, rose to 72.6 percent from 71.9 percent a month earlier, but was still 8 percentage points below the average from 1972 to 2009, suggesting little inflationary pressure.

Fed officials are keeping an eye on how quickly the recovering economy absorbs the excess slack that built up during the recession. With unemployment hovering close to 10 percent, they have said they are likely to keep interest rates extraordinarily low for an extended period.

New home construction contributed to economic growth in the third quarter of 2009 for the first time since 2005. But activity slowed sharply in the fourth quarter and while homebuilder sentiment edged up this month, it remains at levels consistent with poor conditions.

Even with mortgage rates near record lows, demand for home loans remains lethargic. Mortgage applications dipped 2.1 percent last week, the Mortgage Bankers Association said.

Housing starts peaked at a 2.273 million unit annual pace in January 2006 and bottomed at 479,000 units last April. They have been bouncing around between 500,000 and 600,000 units.

Permits for new building projects fell 4.9 percent to 621,000 units last month after rising to a 14-month high of 653,000 in December, the Commerce Department said.

(Additional reporting by Ryan Vlastelica in New York; Editing by Andrea Ricci)

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