U.S. industrial output recorded its best gain in seven months in July as the auto sector bounced back from supply disruptions wrought by Japan's devastating earthquake in March.

The surprisingly strong production data, together with a smaller-than-expected decline in home building last month, further eased fears the economy was at risk of contracting.

I don't think we are headed for a second recession, said Ryan Sweet, a senior economist at Moody's Analytics in West Chester, Pennsylvania.

Industrial output increased 0.9 percent, the Federal Reserve said on Tuesday, after a 0.4 percent gain in June -- nearly double economists' expectations for a 0.5 percent rise.

Manufacturing rose 0.6 percent as motor vehicles production surged 5.2 percent after falling 0.9 percent in June. Excluding autos, manufacturing rose 0.3 percent, pointing to resilience in the sector that has been the economy's main pillar of support, even when regional factory activity has been cooling.

When you take the industrial production report together with July retail sales, it shows consumer spending started this quarter off to a decent start. said Sweet. That all together suggests the economy is starting to show signs of life but it's not booming.

But high rates of national unemployment still are a restraint on the pace of recovery.

The latest data follows earlier reports showing some pickup in nonfarm employment as well as retail sales. The economy barely grew in the first half of 2011, held back by high gasoline prices and supply chain disruptions from Japan.

The industrial production data indicated the Japan-induced disruptions to manufacturing had almost unwound.

HOME BUILDING FALLS LESS THAN EXPECTED

President Barack Obama called again on Tuesday for an extension of a payroll tax cut and urged Congress to approve legislation authorizing more road construction to boost the economy.

The only thing that is holding us back is our politics, Obama said during a tour in Iowa. Our economy can't afford it.

Third-quarter economic growth is currently estimated at an annual rate of about 2.3 percent, an improvement from the second quarter's anemic 1.3 percent pace.

Also supporting the improving tone for the economy, housing starts slipped a less-than-expected 1.5 percent in July to a seasonally adjusted annual rate of 604,000 units as builders broke ground on new multifamily units to meet demand for rental apartments, Commerce Department data showed.

But there is still a hefty overhang of previously owned homes on the market.

There is still too much oversupply in many markets around the country, said Chris Rupkey, chief economist at Bank of Tokyo-Mitsubishi UFJ in new York. Housing starts hit bottom in April 2009, so the downward impact of construction on GDP has moderated.

Investment in home building grew at a 3.8 percent annual rate in the second quarter.

Housing starts for multi-family homes rose 7.8 percent to a 179,000-unit rate in July, and groundbreaking for projects with five or more units was the highest since January.

U.S. financial markets ignored the U.S. data, instead focusing on reports that Germany's economic growth almost stalled in the second quarter while a meeting between French and German leaders failed to calm fears about the euro zone debt crisis.

CONSUMERS STILL PRESSURED

Although the U.S. economy is showing some signs of perking up, the picture from the consumers' point of view is mixed.

Sales at Wal-Mart Stores Inc's U.S. discount stores open at least a year fell 0.9 percent during its second quarter, marking the ninth straight quarterly decline.

They're trading down to stretch their budgets, buying a lower-priced brand of detergent, moving from branded canned goods to private label, and purchasing half gallons of milk instead of gallons, Wal-Mart Chief Executive Mike Duke said.

But luxury department store operator Saks Inc reported a narrower-than-expected quarterly loss and forecast same-store sales growth for the rest of the year.

Consumer spending accounts for about 70 percent of U.S. economic activity and hardly grew in the second quarter.

A 9.1 percent unemployment rate is dampening consumer spending and weighing down on the housing market, whose collapse was the main catalyst of the 2007-09 recession.

While capacity utilization at U.S. industries surged to its highest level since August 2008, economists saw little sign of inflation.

This is another indicator that this sector has dug its way out of the Great Recession hole, said Joel Naroff, chief economist at Naroff Economic Advisors in Holland, Pennsylvania. It's hard to think we are on the eve of destruction when manufacturers are ramping up production.

(Additional reporting by Jason Lange in Washington and Brad Dorfman in Chicago; Editing by Andrew Hay)

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