Housing starts touched a 1-1/2-year high in April, but a drop in building permits to a six-month low implied the housing market recovery may struggle to gain momentum without more government aid.

Tuesday's data indicated the economic recovery was continuing into the second quarter, but worries persist that the debt crisis in Europe could stunt growth in the months ahead as governments there tighten their budgets.

The end of a popular U.S. tax credit could also put a damper on the housing market along with a deluge of foreclosures.

Housing starts rose 5.8 percent to an annual rate of 672,000 units in April, the Commerce Department said. This was the highest since October 2008, just a month after the collapse of investment bank Lehman Brothers.

The gain last month likely reflected a rush by prospective homeowners to take advantage of a federal tax credit for home buyers before the April 30 deadline to sign contracts. They have to close the purchases by the end of June to qualify for the credit. Groundbreaking had increased 5 percent in March.

The increase in demand prompted by the tax credit has lifted construction, but the expiration of the credit on April 30 has made homebuilders wary about continuing to add new homes during the summer, said Ian Shepherdson, chief U.S. economist at High Frequency Economics in Valhalla, New York.

Financial markets had expected housing starts to rise to a 650,000-unit pace last month. Compared with April last year, starts were up 40.9 percent, the largest increase since March 1994.

However building permits, which give a sense of future home construction, dropped 11.5 percent to a 606,000-unit pace last month, the lowest level since October 2009. Markets had expected a 680,000-unit rate in April.

Separately, prices received by U.S. farms, factories and refineries slipped 0.1 percent in April after a 0.7 percent rise in March, the Labor Department said. Markets had expected producer prices to gain 0.1 percent.

INTEREST RATES SEEN ON HOLD

With the housing market still shaky, inflation subdued and worries about Europe hanging over markets, analysts are increasingly coming to the view that the Federal Reserve -- the U.S. central bank -- will extend its ultra-low interest rate policy into next year.

Cleveland Federal Reserve Bank President Sandra Pianalto said on Tuesday inflation expectations remained well anchored. Many of my business contacts continue to talk about wage and price reductions, not increases, she said.

U.S. stocks ended sharply lower as attention reverted to Europe's debt crisis. U.S. government debt prices rallied, while the dollar hit a fresh four-month high versus the euro.

While the economic recovery that started in the second half of 2009 is showing signs of strengthening and broadening out from manufacturing, Wal-Mart Stores Inc (WMT.N) said high unemployment and fragile household finances remain a constraint to spending.

President Barack Obama, whose popularity has dropped over public unhappiness with the economy, said on Tuesday it will take time for Americans to feel the resumption of growth.

We've got a long way to go before this recovery is felt in the lives of all our neighbors and in all the communities that have lost so much ground in this recession and for years before, Obama said during a visit to a steel mill in Ohio.

Hoping to reverse Democratic majorities in both houses of Congress, Republicans have taken aim at the economic policies of the Democratic U.S. president and his allies.

Housing starts in April were lifted by a 10.2 percent rise in groundbreaking for single-family homes to a rate of 593,000 units. This followed a 2.1 percent gain in March.

Starts in the volatile multifamily segment tumbled 18.6 percent to a 79,000-unit annual pace, partially reversing the prior month's 24.4 percent surge.

Despite the drop in permits after two straight months of gains, analysts are cautiously optimistic that home construction will hold up and believe a combination of low mortgage rates and an improving labor market will partially fill the void left by the end of the tax credit.

Permits lead housing starts by one to two months. A National Association of Home Builders survey on Monday showed home-builder sentiment rose to its highest level in more than 2-1/2 years in May on the strengthening economic recovery.

Housing starts should continue to trend higher this year, meaning residential construction will contribute to economic growth, said Sal Guatieri, an economist at BMO Capital Markets Economics in Toronto.

However, until the foreclosure wave ebbs and the overhang of unsold existing homes abates, the recovery in homebuilding will be subdued.

Investment in new home construction contracted in the first quarter after two straight quarters of growth. A flood of foreclosed properties is hampering the housing sector's recovery from a three-year slump.

Last month, building completions increased to 769,000 units, while the inventory of total houses under construction fell to a record low 482,000 units.

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Housing starts graphic: link.reuters.com/wed84k

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(Additional reporting by Pedro Nicolaci da Costa and Caren Bohan; Editing by James Dalgleish)

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