Oct. 4 (Bloomberg) -- Service industries in the U.S. grew at the slowest pace in more than three years last month and a measure of inflation showed the biggest drop on record as the economy lost momentum heading into the fourth quarter.

The Institute for Supply Management's index of non- manufacturing businesses fell to 52.9 from 57 in August. Readings above 50 indicate expansion in industries including banking, retailing and construction that account for almost 90 percent of gross domestic product. The group's measure of prices declined to 56.7 from 72.4, the biggest slide since the survey began in 1997.

Housing and construction dragged the index lower, even as retailers, health care and finance firms reported an increase in activity. The Dow Jones Industrial Average closed at a record as some investors speculated the Federal Reserve will hold off on interest-rate increases and may reduce borrowing costs next year. Traders will turn their attention to scheduled remarks on the economy later today by Fed Vice Chairman Donald Kohn.

``Growth has downshifted to a slower pace that will hold inflation in check and keep the Fed on the sidelines for the rest of the year,'' said Chris Rupkey, senior financial economist at Bank of Tokyo-Mitsubishi UFJ Ltd. in New York. ``The real worry is whether business expectations for the outlook will continue to deteriorate further, and what this will mean for Fed policy next year.''

Factory Orders

A government report today on factory orders suggested that production is also easing. Orders were unchanged in August after a 1 percent decline in July, the Commerce Department said. Excluding the volatile transportation equipment category, orders fell 0.7 percent, the biggest decrease since February.

``There is very little doubt that the economy is slowing,'' said Steven Wood, president of Insight Economics LLC, a forecasting firm in Danville, California. ``However, it is still unclear just how sharply the economy is slowing, so the Fed will have to monitor the growth risks very closely.''

In a further sign of a slowing economy, ADP Employer Services said companies in the U.S. added 78,000 jobs in September, the fewest this year. The increase followed a 107,000 gain in August.

At the same time, the Mortgage Bankers Association said today applications for housing loans rose by the most since June of last year. The association's index of applications to buy a home or refinance an existing loan increased 11.9 percent to 633.9 last week. The level is the second-highest this year. Refinancing surged 17.5 percent, also the biggest rise since June 2005, and home purchases rose 7.6 percent last week.

Dow Closes at a Record

The Dow Jones Industrial Average rose 123 points, or 1 percent to close at an all-time high of 11850.61. A speech from Fed Chairman Ben S. Bernanke reaffirmed a view that policy makers are done raising interest rates.

The housing market is in the midst of a ``substantial correction'' that will lop about a percentage point off economic growth in the second half and remain a drag on expansion next year, he said after addressing the Economic Club of Washington.

The ISM index was expected to fall to 56, the median forecast in a Bloomberg News survey of 58 economists. The measure averaged 59.6 in the first half of the year.

The purchasing managers reported falling prices for nine commodities last month, compared with five in August. Fuels, including diesel, gasoline, heating oil and natural gas, dominated the list of declines. Service industries also reported lower labor costs for September.

New Orders

The group's gauge of new orders for U.S. non-manufacturing industries rose to 57.2 from 52.1 in August. The index of employment increased to 53.6 last month from 51.4.

``With new orders spiking upward as they did, as well as employment going up, that's a good upward movement,'' said Anthony Nieves, chairman of the survey and senior vice president for supply management at Hilton Equipment Corp. in Beverly Hills, California.

News wasn't all positive today for retailers. Wal-Mart Stores Inc., the world's largest retailer, unexpectedly lowered its estimate for U.S. comparable-store sales growth in September after discovering mistakes in calculations at 235 locations.

Service industries are cooling in Europe as well. Royal Bank of Scotland Group Plc's index fell to 56.7, a 10-month low, from 57.4 in August, the company said today in London.

In the U.S., economic growth has slowed with the end of the five-year housing boom, making it harder for consumers to borrow against the equity in their homes and making them feel less wealthy.

Second Half

The economy is forecast to grow at an average annual rate of 2.7 percent in the last half of this year, in line with the 2.6 percent pace registered in the second quarter, according to a Bloomberg survey of economists from Sept. 1 to Sept. 7. The economy grew at a 5.6 percent rate in the first quarter.

Home construction fell at an annual rate of 11.1 percent in the second quarter, the biggest decline since the same three months in 1995, the government said last week. The decrease has prompted builders to lower prices to drum up demand.

The weakness has resulted in smaller home equity gains, which homeowners had relied on the last several years as a source of cash. Homeowners extracted a net $497 billion at an annual rate from home equity in the second quarter, down from $649.2 billion in the first three months of the year, according to figures from Fed researcher James Kennedy.

Fed policy makers will keep interest rates unchanged for a third straight month when they meet on Oct. 24-25, according to trading in futures contracts tied to the federal funds rate. The Fed ended a two-year cycle of rate increases in August, keeping its benchmark rate at 5.25 percent.

Manufacturing is also slowing, according to another report this week from the Institute for Supply Management. The group's manufacturing index for September dropped to the lowest since May 2005 while still pointing to expansion.

To contact the reporter on this story: Bob Willis in Washington bwillis@bloomberg.net

Last Updated: October 4, 2006 16:16 EDT