June 17 (Bloomberg) -- Industrial production in the U.S. unexpectedly fell in May as shrinking output by utilities and consumer-goods makers overshadowed a gain in auto manufacturing.

Production in factories, mines and utilities declined 0.2 percent last month after dropping 0.7 percent in April, the Federal Reserve reported today in Washington. Capacity utilization, which measures the proportion of plants in use, fell to 79.4, the lowest since September 2005, when Hurricane Katrina disrupted manufacturing and oil production along the U.S. Gulf Coast.

Factories are trimming output as the housing slump deepens, food and fuel prices climb and credit restrictions make borrowing tougher. The report indicates that gains in foreign demand alone may no longer be enough to prevent a deeper contracting in manufacturing.

``Manufacturing is contracting and the second quarter will be the third in a row of decline, and the largest one so far,'' said Nigel Gault, chief U.S. economist at Global Insight Inc. in Lexington, Massachusetts. ``It's a very, very mixed bag. There are sectors of manufacturing linked to export, which are doing well, and there are other areas linked to U.S. housing that are being hurt.''

Other government reports today showed builders in the U.S. broke ground in May on the fewest new houses in 17 years, while prices paid to U.S. producers rose more than forecast.

Housing starts fell 3.3 percent to a 975,000 pace, less than forecast, from a revised 1.008 million in April, the Commerce Department said. The reading was the lowest since March 1991. Building permits, a sign of future construction, fell 1.3 percent to a 969,000 rate.

Producer Prices

The 1.4 percent jump in producer prices was the biggest gain since November and followed a 0.2 percent increase in April, the Labor Department said today in Washington. So-called core producer prices that exclude fuel and food increased 0.2 percent, matching economists' projections.

Economists had forecast industrial production would rise 0.1 percent, according to the median of 68 estimates in a Bloomberg News survey. Projections ranged from a decline of 0.4 percent, to a gain of the same amount.

Capacity utilization was forecast to be unchanged at 79.7 percent, according to the survey median. Estimates ranged from 79 percent to 80 percent.

Economists track plant operating rates for indications of pressure on factories' ability to produce goods with existing resources, with lower rates reducing the risk of bottlenecks in production that can force prices higher. Capacity utilization has averaged 81 percent over the past 30 years.

Tame Inflation

``With manufacturing slowing down and demand weak, this is not the type of economy that generates a lot of inflation.'' Carl Riccadonna, an economist at Deutsche Bank Securities Inc. in New York, said before the report. ``We're not seeing this pervasive inflation problem like we did in the '70s.''

A regional survey yesterday indicated the factory slowdown will extend in to June. The Fed Bank of New York's general economic index unexpectedly dropped, the bank reported yesterday. The contraction reinforced concern that the economy will experience a degree of stagflation, where growth slows and inflation accelerates.

A similar report from the Philadelphia Fed is due June 19. Economists surveyed by Bloomberg News project manufacturing in that region will also contract.

Manufacturing, which accounts for about four-fifth of the industrial production report, was unchanged last month after a 0.9 percent decline in April. Excluding autos, factory output fell 0.2 percent after a drop of 0.4 percent.

Consumer Goods

Production of consumer goods fell 0.2 percent, led by declines in manufacturing of appliances and furniture, which fell 0.3 percent.

Production of motor vehicles and parts increased 1 percent, the first gain since November.

The resolution of a three-month strike by General Motors Corp.'s largest axle supplier may have helped lift auto output. Detroit-based General Motors plans to return to full production this month as it recovers from the strike by American Axle & Manufacturing Holdings Inc. workers. The walkout, which ended May 26, stopped production of about 330,000 units, and cost the largest U.S. carmaker $2.6 billion.

``We're going to see three months in a row where vehicle assembly is going to reverse course'' as manufacturers recover from the strike, said Mike Englund, chief economist with Action Economics LLC in Boulder, Colorado.

Caterpillar Inc., the world's largest maker of earthmoving machinery, said exports are expected to account for about 70 percent of sales this year, up from 62 percent a year earlier. The Peoria, Illinois-based company also plans to spend $1 billion to boost its U.S. manufacturing capacity by 2010.

Mining production rose 0.1 percent in May, following a decline of 0.6 percent. Utilities output dropped 1.8 percent after no change in April.

Milder-than-average temperatures last month may have limited utility use. The average temperature in May in the U.S. was 60.3 degrees Fahrenheit, 0.7 degrees below the historical average, according to the National Climatic Data Center in Asheville, North Carolina.

To contact the reporter on this story: Courtney Dentch in New York at cdentch1@bloomberg.net.

Last Updated: June 17, 2008 09:37 EDT