Nov. 1 (Bloomberg) -- Manufacturing in the U.S. expanded at the slowest pace in more than three years last month and construction spending unexpectedly declined because of a deteriorating housing market.

The Institute for Supply Management's factory index fell to 51.2, lower than forecast, from September's 52.9. A reading higher than 50 signals expansion. A measure of prices paid for raw materials dropped to the lowest in more than four years. Outlays for construction fell 0.3 percent in September following no change, the Commerce Department said in Washington.

Manufacturers are providing little spark for the economy, which grew the least since 2003 last quarter. Together with weaker consumer confidence reported yesterday, the figures spurred traders to begin wagering the Federal Reserve will cut interest rates by the end of March.

``You can see the evidence of economic slowing here almost every day,'' said Roger Kubarych, senior economic adviser at HVB America Inc. in New York and a former Fed economist. The Fed is ``going to have to come off this bias toward tightening very soon. The risks of an economic slowdown are very great.''

Treasury notes gained for a seventh straight day and the dollar retreated. Norbert J. Ore, chairman of the ISM's survey committee, told reporters on a conference call today that he wouldn't be surprised if the index fell below 50. It hasn't done that since April 2003. He said he doubted it would stay there ``very long.''

Companies may be reluctant to spend more on equipment as the five-year economic expansion shows signs of strain.

`Significant Slowdown'

``We are in a significant slowdown in factory activity,'' said Richard DeKaser, chief economist at National City Corp. in Cleveland. ``The slowdown in overall economic growth is taking a toll on the factory sector and the reality of somewhat bloated inventories for certain goods is prompting a cutback in production.''

Fed policy markers may take comfort in the drop in the index of prices manufacturers pay for raw materials, which suggests inflation pressures are subsiding. The index fell to 47, from 61 in September. The measure is down 26 points over the last two months, the biggest back-to-back drop since records began in 1948.

Jobs Report

Attention now turns to the September employment report from the Labor Department on Nov. 3. The economy created 120,000 last month, rebounding from a 51,000 gain in September that was the weakest in a year, according to the median estimate of economists surveyed by Bloomberg News. Hiring would still fall short of this year's 137,000 monthly average.

Economists expected the overall index to rise to 53, according to the median of 72 forecasts in a Bloomberg News survey. Estimates ranged from 49 to 56.

Construction spending in the U.S. fell in September as homebuilding declined for the sixth straight month. Spending on private residential construction hadn't fallen for six straight months since the first half of 1995.

Two other reports on housing showed the slump continues. The National Association of Realtors said that contracts to buy previously owned homes fell 1.1 percent in September. Also, the Mortgage Bankers Association said that applications for new home purchases declined to the lowest level since November 2003, suggesting the slump in real estate shows few signs of ending.

The Tempe, Arizona-based institute's measure of prices paid for materials fell to the lowest level since February 2002. The gauge of inflation, dropped to 47 from 61. The monthly decline was the largest since July 1973. Economists surveyed by Bloomberg had expected a reading of 58.

Futures Trading

The reports helped swing investor sentiment toward the probability of a Fed rate cut by the end of March, based on the price of futures linked to the rate on the Chicago Board of Trade. Traders saw a 66 percent chance of such a move as of 4 p.m., up from 18 percent on Oct. 26, before the government said third-quarter economic growth lagged forecasts. It was the first time since Oct. 5 that traders expected such a move in March. A further reduction is anticipated by the August meeting.

Fewer factories are paying more for commodities including crude oil, which may make it less likely they'll have to raise prices on finished goods. The price of a barrel of crude oil traded on the New York Mercantile Exchange fell to $56.82 on Oct. 20, the lowest level this year.

Fed Stance

Fed policy makers last week kept their benchmark lending rate at 5.25 percent for a third month and dropped a reference in their accompanying statement that energy and commodity costs risked a pickup in inflation.

The yield on the benchmark 10-year Treasury note declined about 4 basis points to 4.56 percent at 4:05 p.m. in New York. The dollar weakened against the euro in the minutes after the figures were released before trading little changed. Stocks retreated.

The manufacturing institute's new orders index, which makes up about a third of the total index, fell to 52.1, the lowest since May 2005, from 54.2 in September.

The institute's production index, a measure of work being performed, dropped to 51.9, the lowest since April 2003, from 56.1 in September. The supplier deliveries gauge, which covers how long it takes companies to receive goods, dropped to 50.2 from 54.1. The October reading was the lowest since June 2003.

The measure of orders in backlog declined to 44.5, which was the lowest since March 2003, from 46.5. The group's inventory index rose to 49.4 from 46.4.

Inventories

A build-up in inventories is pushing some companies to cut production as a way to clear their shelves. Caterpillar Inc., the world's largest marker of earthmoving equipment, started cutting back inventory in its third quarter and said on Oct. 20 that it expects a ``sharp drop'' in truck engine sales.

``We have work to do on our production facilities,'' Caterpillar Chief Financial Officer David Burritt said in an interview on Oct. 20. ``We see our business entering a pause, if you will, but beyond that we're optimistic about the future.''

ISM's manufacturing employment index rose to 50.8 last month from 49.4 in September.

Slowing auto production probably will weigh on factory output in coming months. General Motors Corp., Ford Motor Co. and Daimler Chrysler AG's Chrysler have said they are trimming production for the rest of this year because of slumping sales. In addition, Ford the second-largest U.S. automaker said Oct. 30 that it plans to cut North American production as much as 12 percent in the first half of next year.

The U.S. economy expanded at a 1.6 percent rate in the third quarter, the slowest pace in more than three years, the Commerce Department reported on Oct. 27.

To contact the reporter on this story: Courtney Schlisserman in Washington at cschlisserma@bloomberg.net; Joe Richter in Washington at jrichter1@bloomberg.net

Last Updated: November 1, 2006 16:21 EST