U.S. housing starts fell more sharply than expected to the lowest rate in more than three years, while core producer prices dipped unexpectedly, according to government reports on Tuesday that confirmed a fast-cooling economy.

The reports bolstered market views that the U.S. Federal Reserve will hold interest rates steady on Wednesday and is likely to refrain from further hikes this year.

The Commerce Department said U.S. housing starts fell 6.0 percent in August to an annual pace of 1.665 million units, the lowest since April 2003, compared to a downwardly revised 1.772 million in July.

Economists had forecast August housing starts to decline to 1.75 million units from July's originally reported pace of 1.795 million.

Compared to a year earlier, August housing starts were down 19.8 percent from the August 2005 pace of 2.075 million units.

Permits for future groundbreaking, an indicator of builder confidence, fell 2.3 percent to a 1.722 million-unit annual pace, the lowest in four years. Economists had expected the Commerce Department to report August permits at a 1.745 million pace.

It's shockingly weak housing data, said Greg Anderson, senior currency strategist at ABN Amro in Chicago. We knew the Fed was going to pause on Wednesday. It does make it much more likely that they'll stay paused thereafter if the housing sector is this weak.

U.S. single-family starts dropped 5.9 percent to a pace of 1.360 million units, the lowest level since February 2003. Single family permits were down 3.5 percent to an annual pace of 1.279 million units, the lowest since December 2001.

Single-family permits in the Midwest were at their lowest pace since May 1993, while in the Northeast, they were the lowest since January 1996.

The report came a day after an industry survey showed that home builder optimism sank for the eighth straight month in September to the lowest level in more than 15 years. The closely watched National Association of Home Builders' index of homebuilder sentiment declined 3 points in September to 30, the lowest since February 1991, when the economy had slipped into recession.

CARS DRAG DOWN CORE PPI

The Labor Department said U.S. producer prices edged up a smaller-than-expected 0.1 percent in August and core prices posted a surprise drop of 0.4 percent, the biggest since April 2003.

The decline in the core producer price index, which strips out volatile food and energy costs, reflected a 2.6 percent drop in auto prices and a 3.4 percent decline in the price of light trucks and SUVs, the Labor Department said.

But even stripping out those automotive price declines, core producer prices would have been unchanged, it said.

Wall Street economists had expected the report, which comes one day ahead of a Federal Reserve meeting on interest rates, to show both overall and core producer prices had risen 0.2 percent last month.

The decline in core producer prices followed a 0.3 percent dip in July, marking the first back-to-back monthly declines since November and December 2002.

The Fed's policy-setting committee meets on Wednesday, and markets widely anticipate that the U.S. central bank will not resume a two-year rate hike campaign that was paused last month.

U.S. Treasury debt prices rallied after the tamer-than-expected producer prices, while the dollar fell against the euro and yen.

Marc Pado, U.S. market strategist at Cantor Fitzgerald & Co in San Francisco, said the data could point up more serious questions about the economy than the future direction of interest rates.

The question is now what? What's more important - the economy or interest rates? he said. Even though this is a great number for inflation and for rate (hikes) coming to the end of their cycle, we have to move on to the next concern, which is the economy.

Separately, a retail industry report on Tuesday showed some resilience in consumer spending as U.S. chain store sales rose last week as cooler weather boosted sales of seasonal items. Redbook Research said sales were up 4.1 percent year-on-year during the week ended September 16, following an increase the week before.

Inflation ABN Amro