Softer-than-expected U.S. housing starts last month and a drop in prices paid at the farm and factory gate pointed to an anemic economic recovery, backing views that interest rates could stay low for a while.

A Commerce Department report on Tuesday showed groundbreaking for new homes rose 0.5 percent to an annual rate of 590,000 units in September, shy of forecasts for a 610,000 unit rate. August's figure was revised down to 587,000. For a graphic showing housing starts data, click on:

http://graphics.thomsonreuters.com/109/US_HSGSTS1009.gif

Separately, the Labor Department said its producer price index -- a gauge of prices received by farms, factories and refineries -- dropped 0.6 percent last month after rising 1.7 percent in August. Analysts had expected prices to hold steady.

The expectations are for a very tepid economic recovery. The recovery is firmly in place, but I don't think that consumers are going to recognize this until we start to see job growth, said John Canally, an economist and investment strategist at LPL Financial in Boston.

U.S. stocks ended down on the economic data that overshadowed yet another set of strong results from bellwethers such as Apple Inc and Caterpillar .

Prices for U.S. government debt rallied as investors viewed the reports as more evidence that the Federal Reserve would keep lending rates near zero for a prolonged period. The Fed has held benchmark overnight rates near zero since December.

San Francisco Fed President Janet Yellen said on Tuesday she did not anticipate the U.S. central bank would withdraw its support to the economy any time soon and adding that economic conditions would be the main deciding factor.

The rise in housing starts last month was held back by a 15.2 percent drop in groundbreaking in the volatile multifamily sector. Starts on single-family homes, often seen as a better harbinger for the direction of the market, rose 3.9 percent, partially reversing a fall in August.

Compared with September last year, housing starts were down 28.2 percent.

DOUBTS OVER TAX CREDIT

The housing market, the main catalyst of the worst U.S. recession since the 1930s, is crawling out of a three-year slump and analysts believe residential investment probably contributed to economic growth in the third quarter.

The economy is expected to have started growing again in the July-September period after a downturn that began at the end of 2007.

Analysts reckoned the disappointing housing start numbers in September could be related to worries over the expiration of a popular $8,000 tax credit for first-time buyers. The incentive, which ends next month, has been widely cited as a crucial force behind the housing market's steady recovery.

Housing and Urban Development Secretary Shaun Donovan on Tuesday expressed doubts that the country could afford to extend the tax credit. But he said the administration had not yet decided whether to back an extension.

A survey on Monday showed confidence among U.S. home builders had edged down this month amid worries over whether the tax credit would be extended. The program has cost the U.S. government about $10 billion.

New building permits, which give a sense of future home construction, unexpectedly fell 1.2 percent to an annual pace of 573,000 units in September, the Commerce Department said. It was the biggest percentage decline since April and took permits 28.9 percent below their year-ago level.

The number of housing units completed last month dropped to 693,000, the lowest on records going back to 1968. In addition, the inventory of houses under construction hit a record low 582,000 units and the number of permits authorized but not yet started also dropped to an all-time trough at 96,900 units.

Analysts this was a positive development as fewer homes built would lead to a healthy housing market recovery.

The decline in housing completions leaves us with the conclusion that the number of unsold new and existing homes will continue to decline in the months ahead, which will help stabilize home prices, said Tony Crescenzi, strategist and portfolio manager at Pimco in Newport Beach, California.

In the producer price report, the Labor Department said prices were down 4.8 percent on the year.

Excluding food and energy, prices declined 0.1 percent in September from the prior month, with the year-over-year increase slowing to 1.8 percent from the 2.3 percent gain seen in the 12 months through August. The year-on-year increase was the slowest in two years.

Still, analysts did not believe that deflation -- an economically disabling, broad-based decline in consumer prices -- was a major threat given the U.S. dollar's <.DXY> recent drop to 14-month lows against a basket of currencies.

We see higher prices for imports down the road, said Craig Thomas, a senior economist at PNC Financial Services Group in Pittsburgh.

(Additional reporting by Lisa Lambert; Editing by James Dalgleish)

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