Jan. 3 (Bloomberg) -- Manufacturing in the U.S. unexpectedly expanded and construction spending fell less than forecast, signaling the worst of the economic slowdown is over.

The Institute for Supply Management's manufacturing index rose to 51.4 in December from 49.5 in November, when activity contracted for the first time in more than three years. Spending on construction dropped 0.2 percent in November after a 0.3 percent drop in October that was smaller than originally reported, the Commerce Department said today in Washington.

The figures suggest the economy will extend the five-year economic expansion into 2007, weathering a slump in housing and a factory decline that weakened growth in the past three quarters. The dollar rallied and stocks initially advanced before erasing most of their gains after minutes of the Federal Reserve's meeting last month showed central bankers were still concerned about inflation.

``All the key numbers are looking slightly better,'' said Peter Kretzmer, a senior economist at Banc of America Securities LLC in New York. ``I just would not necessarily count on this being the beginning of a strong upswing. The manufacturing sector is growing very slowly.''

Fed officials saw the risk of inflation remaining too high as their ``predominant concern'' while predicting economic growth may be ``somewhat uneven'' in the coming quarters, according to the minutes of the Dec. 12 meeting released today.

Several Fed officials judged that ``the downside risks to economic growth in the near term had increased a little and become a bit more broadly based than previously thought,'' the minutes also said.

Working Off Inventories

Growth in exports and resilient consumer spending have helped work down an inventory glut in many industries. A rise in orders and production may help provide support to an economy beset by slumps in housing and automobile manufacturing, economists said.

Economists surveyed by Bloomberg News had expected the total manufacturing index to rise to 50. Forecasts ranged from 48.4 to 52.5. A reading above 50 signals an expansion.

For a second month, more factories reported a shrinking labor force, the ISM survey indicates. The group's employment index was 49.7, up from 49.2 in November.

Earlier today, another private report showed that companies in the U.S. unexpectedly shed 40,000 jobs in December, the first decline since April 2003.

The decrease followed a gain of 158,000 in November, according to an ADP Employer Services report based on data from 307,000 businesses with almost 18 million workers on payrolls.

`Eye-Opener'

``This is certainly an eye-opener,'' said Douglas Porter, deputy chief economist at BMO Capital Markets in Toronto. ``If employment is beginning to weaken, that would knock a leg out of the economy. This raises the stakes for Friday'' when government figures are released.

Following the ADP report, economists at Morgan Stanley and Goldman Sachs Group Inc. were among those that pared estimates of how many jobs the Labor Department will report were created last month. The median December payroll estimate of economists surveyed by Bloomberg News fell to 100,000 from 115,000 prior to the ADP figures.

Construction spending in November was restrained by an eighth consecutive decline in private residential projects, the Commerce Department report showed. A 1.4 percent gain in private non-residential construction, reflecting increases in spending on transportation projects, hotels and commercial space, helped offset the 1.6 percent decline in residential building.

Price Pressures Eased

The Institute for Supply Management's measure of prices paid for raw materials fell to 47.5 from 53.5 the month before. The prices-paid measure was forecast to rise to 54, according to the median of economists' estimates in a Bloomberg News survey.

The supply management institute's new orders index, which makes up about a third of the total index, rose to 52.1 from 48.7. The production index, a measure of work being performed, rose to 51.8 from 48.5.

The institute's supplier deliveries gauge, which covers how long it takes companies to receive goods, rose to 53.4 last month from 52.8. The measure of orders in backlog declined to 45 from 46.5 in November.

The inventory index fell to 48.4 in December from 49.7.

``The manufacturing sector had a good month during December,'' Norbert Ore, chairman of the ISM's business manufacturing survey, said in an interview. The index probably won't advance much more because the economy is cooling and companies are still paring inventories, he said.

`Slowing' Trend

``I do not think there is a lot of strength to drive us above this 51.4 level,'' said Ore. ``The trend is that things are slowing.''

The economy grew at the slowest pace of the year during the third quarter, and wasn't expected to accelerate in the final three months of 2006, according to a Bloomberg survey of economists early last month. Slow growth and bulging inventories may be making businesses more cautious about spending, economists said.

Losses and reduced sales have forced General Motors Corp. and Ford Motor Co. to buy out more than 70,000 factory workers and reduce production. Tom LaSorda, chief executive of DaimlerChrysler AG's Chrysler, said his company will reduce capacity after a $1.5 billion third-quarter loss.

Illinois Tool Works Inc., the maker of Wilsonart countertops and Duo-fast nail guns, cut its fourth-quarter profit forecast for the second time this year as residential construction and auto production sagged. The housing and automotive industries make up about 11 percent of Illinois Tool's total sales.

CEOs Lose Confidence

``CEOs are expecting a period of slower growth compared with the first half of 2006,'' Terry McGraw, chairman of the Business Roundtable and chairman and chief executive officer of McGraw-Hill Cos., said in a statement Dec. 12. A survey by the Business Roundtable found confidence among U.S. chief executives was the lowest in more than three years last quarter on expectations economic growth will slow

The Fed on Dec. 12 kept its benchmark interest rate at 5.25 percent for a fourth straight meeting, and forecast a moderate pace of growth ``on balance over coming quarters.''

To contact the reporter on this story: Joe Richter in Washington at Jrichter1@bloomberg.netBob Willis in Washington bwillis@bloomberg.net

Last Updated: January 3, 2007 17:36 EST