The Commerce Department said on Wednesday construction of new housing fell 4 percent in December to a seasonally adjusted annual rate of 557,000 units as construction of single-family homes slipped.
But building permits -- which give a sense of future home construction -- soared 10.9 percent to 653,000 units last month, the highest level since October 2008 and above market expectations for 590,000 units.
At first glance housing starts were disappointing. But, they were offset by a huge jump in building permits. The data is suggestive of a continued gain in housing construction over the next several months, said Michelle Meyer, economist at Barclays Capital in New York.
Analysts polled by Reuters had expected housing starts to rise to 580,000 units.
November's housing starts were revised to 580,000 units from the previously reported 574,000 units.
A recovery in the housing market, whose collapse triggered the most brutal U.S. recession since the Great Depression of the 1930s, is considered key to a healing of the U.S. economy.
A separate report from the Labor Department showed producer prices rose 0.2 percent in December as food prices surged, and recorded their largest year-on-year gain in 14 months.
But core prices, which exclude food and energy, were unchanged on the month and up just 0.9 percent on the year, showing inflation pressures remained tame.
U.S. financial markets largely ignored the data. Stocks suffered their worst slide of 2010 as a decision by China to further tighten lending raised worries about a global economic recovery.
Declining stocks and concerns over Greece's ability to finance its budget deficit lifted prices for U.S. government debt, sending benchmark yields to one-month lows. The U.S. dollar hit a five-month high against the euro.
Housing is on the mend after a three-year slump, thanks to a popular tax credit for first-time buyers and low mortgage rates. New home construction contributed to economic growth in the third quarter of 2009 for the first time since 2005.
But data such as pending home sales and homebuilder sentiment have hinted at potential weakness in the sector.
A slip back in the housing recovery could complicate matters for President Barack Obama, whose policy agenda -- including boosting economic growth and job creation -- was dealt a blow by his Democratic Party's loss of a key Senate seat on Tuesday.
SINGLE-FAMILY STARTS FALL
For the 2009 full year, overall new home construction activity dropped a record 38.8 percent to an all-time low of 553,000 units, the Commerce Department said.
Starts for single-family homes fell 6.9 percent last month to an annual rate of 456,000 units after rising 4.0 percent in November. Groundbreaking for the volatile multifamily segment rose 12.2 percent to a 101,000 unit annual pace, after surging 69.8 percent in November.
While bad weather was probably largely to blame for the drop in groundbreaking activity last month, the housing market recovery is likely to slow when the tax credit expires later this year, analysts said.
There is still reason to be cautious. By the middle of this year the homebuyer tax credit will expire and mortgage rates will probably rise, developments that will exert a drag on sales, said Abiel Reinhart, an economist at JPMorgan in New York.
Pressure could also come from steps by the Federal Housing Administration to increase borrowing costs for homeowners getting loans backed by the government in a bid to shore up the agency's finances and avoid a taxpayer bailout.
Mortgage rates have been held low by the Federal Reserve's program to buy mortgage-related securities in the market. The U.S. central bank is scheduled to end the program in March.
The Mortgage Bankers Association on Wednesday reported that demand for U.S. home loans rose last week for the third straight week as a drop in mortgage rates to a one-month low stoked applications for refinancing.
Muted inflation pressures and the still unsettled housing market should allow the Fed to honor its pledge to keep overnight lending rates low for an extended period. Officials next meet on January 26-27 to deliberate on monetary policy.
We expect the combination of a weak labor market and a tepid recovery to keep a lid on producer pricing pressures, said Ian Pollick, economics strategist at TD Securities in Toronto.
(Additional reporting by Lisa Lambert in Washington, Lynn Adler and Julie Haviv in New York; Editing by Leslie Adler)