Aug. 16 (Bloomberg) -- Consumer prices in the U.S. rose at the slowest pace in five months while home construction fell and industrial production climbed less than expected, validating the Federal Reserve's assertion that interest rates are high enough to slow the economy and tame inflation.

Prices excluding food and fuel rose 0.2 percent after four months of 0.3 percent increases, the Labor Department said in Washington. Homebuilding dropped to the lowest in almost two years, the Commerce Department reported, and the Fed said output at factories, mines and utilities expanded 0.4 percent, half as much as in June.

Bonds and stocks extended the rally spurred by yesterday's report showing a drop in producer prices as traders judged Fed Chairman Ben S. Bernanke may be done lifting borrowing costs after two years of nudging rates higher. The dollar weakened.

``If the Fed had to vote today, they'd probably keep the rate unchanged,'' said Lynn Reaser, chief economist at the Investment Strategies Group at Bank of America Corp. in Boston. ``This report would be considered a big victory for Bernanke.''

The yield on the benchmark 10-year Treasury note fell almost 7 basis points to 4.86 percent at 5:11 p.m. in New York. The Standard & Poor's 500 Index rose 9.85, or 0.8 percent, to 1295.43, the highest in three months.

``Growth is slowing enough to eventually get inflation numbers down to where the Fed would like to see them,'' said Peter Hooper, chief economist at Deutsche Bank Securities Inc. in New York. Today's figures ``certainly come down supportive of the Fed's most recent decision and supportive of the direction Bernanke is taking them.''

Boon for Bernanke

The reports give a boost to Bernanke, whose critics charged that by advocating a pause in the Fed's rate increases, he risked allowing inflation to get out of control. The chairman, who succeeded Alan Greenspan in February, first flagged a suspension in credit tightening in April.

``It's not a total victory yet, but it's pretty close to cosmic confirmation for Bernanke and the Fed,'' said Gregory Miller, chief economist at SunTrust Banks Inc. in Atlanta. ``What was most important in his statement earlier this month was his prediction that the inflation numbers would moderate, and before these reports they really weren't doing so.''

Pimco Call

The Fed is now done raising rates and will be cutting them next year, said Andrew Balls, a global strategist at Pacific Investment Management Co. in Newport Beach, California.

Bill Gross, the firm's chief investment officer, last month heralded the start of a bull market for bonds. He's been saying for a year that the Fed is nearly done, even as the central bank pushed rates higher, stopping only last week.

At the same time, the proportion of industrial capacity in use rose to 82.4 percent, the highest since June 2000. Rising factory operating rates increase the risk of bottlenecks in the production process than can force prices upward.

``Product markets are, in our view, continuing to tighten, which will keep inflation pressures strong,'' said Stephen Stanley, chief economist at RBS Greenwich Capital in Greenwich, Connecticut.

Home construction in the U.S. dropped last month to the lowest level in almost two years, the Commerce Department reported. Housing starts fell 2.5 percent, more than forecast, to an annual rate of 1.795 million, and building permits, declined 6.5 percent, the most since September 1999.

The consumer price index is the government's broadest gauge of inflation. Including food and energy, prices rose 0.4 percent from June and 4.2 percent from a year ago.

Almost 60 percent of the CPI covers prices consumers pay for services, ranging from medical visits to airline fares and movie tickets.

Producer Prices

Prices paid to U.S. producers excluding food and energy unexpectedly fell last month, providing the first piece of evidence since last week's Fed meeting that backs their forecast that inflation will slow. The core producer price index, not counting food and energy, fell 0.3 percent, the first decrease since October, the government said yesterday. Total producer prices rose 0.1 percent.

Policy makers at the Fed have scheduled their next vote on interest rate policy for Sept. 20. The central bank on Aug. 8 refrained from raising its interest rate target for the first time in two years, while leaving the door open for future increases.

Inflation has been ``elevated'' and remains a risk, the Federal Open Market Committee said in text accompanying its announcement to hold interest rates at 5.25 percent. ``However, inflation pressures seem likely to moderate over time, reflecting contained inflation expectations and the cumulative effects of monetary policy actions and other factors restraining aggregate demand.''

Retail Sales

While last week's report on retail sales suggested strong consumer spending, data starting this week probably will paint a less robust picture, economists said. That would further support the Fed's expectations that slower growth will damp inflation.

Interest-rate futures show traders see a less than 50 percent chance that the Fed will raise its target rate to 5.5 percent by the end of the year.

Another month of inflation data will be released before the FOMC's next meeting.

Energy prices rose 2.9 percent in July after falling 0.9 percent a month earlier. Gasoline prices rose 5.3 percent, following a 1 percent decline in June.

Food prices, which account for about a fifth of the CPI, rose 0.2 percent in July after rising 0.3 percent the month before.

Housing Costs

Housing costs, which include some energy costs and account for one-third of the index, rose 0.3 percent after rising 0.2 percent. A category designed to track rental prices rose 0.4 percent for a second straight month. Airfares rose 1.3 percent last month.

Rising rents, which account for almost 40 percent of the core CPI, are contributing to inflation. Rising mortgage interest rates and higher prices are making buying a house less affordable and renting more attractive. Improving demand and limited supply are making it easier for landlords to pass increased costs by raising rents, economists said.

``It does appear that the rent trend is accelerating but even excluding rents and owners' equivalent rent there's a broad-based gain,'' said Julia Coronado, a senior economist at Barclays Capital in New York.

The cost of medical care rose 0.2 percent, following a 0.3 percent increase in June.

After the July increase in consumer prices, inflation adjusted average weekly earnings fell 0.1 percent, the Labor Department said.

Today's report puts the three-month annual rate of consumer price increases at 4.5 percent.

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

Last Updated: August 16, 2006 17:46 EDT