Deepening slump envelops factory sector

WASHINGTON (Reuters) - A spreading economic malaise seeped into U.S. factories in February and March as waning demand more than offset the export benefits of a cheaper dollar, a series of reports showed on Monday.

A Federal Reserve report on industrial output showed factories ran at their slowest rate in more than two years during February while a key gauge of factory business in the Northeastern U.S. slumped to a record low in March.

Taken together, the reports reinforced concern that the world's largest economy stalled during the first quarter and was in an actual downturn, though Bush administration officials refuse to concede a recession has started.

The New York Fed said its "Empire State" gauge of general business activity plunged in March to a record minus 22.23 from minus 11.72 in February, far worse than analysts had expected, as was the case with the broader industrial production report.

The Fed report showed overall industrial production by the nation's mines, factories and utilities fell an unexpectedly steep 0.5 percent in February. That followed a slight 0.1 percent January gain and was the biggest decline in total output since last October.

Market participants, transfixed by developments in the U.S. financial sector after a weekend collapse of one large firm and new Fed action to add liquidity, paid scant attention to the latest economic numbers.

After see-sawing throughout the day, the Dow Jones industrial average ended up 0.18 percent at 11,972.25. The Nasdaq Composite Index posted a 1.6 percent loss to close at 2,177.01.

Investors scrambled for safety into U.S. Treasury securities, driving prices up for longer maturities and yields down ahead of a Fed policy-setting meeting on Tuesday that is widely expected to deliver the central bank's next move, a hefty cut in its benchmark federal funds rate.

The stress on factories showed up in the measure of manufacturing, with output down 0.2 percent in February after being flat in January. That left the manufacturing sector running at 79.3 percent of total operating capacity, the lowest rate since 79.2 percent in October 2005.

"The implication for the economy is that the manufacturing sector, even though it benefits substantially by a weaker dollar, is in decline, hurt by a domestic slowdown," said economist Cary Leahey of Decision Economics Inc in New York.

"This report is saying that the economy is in recession in the first quarter," Leahey added.

Separately, the National Association of Home Builders said builder sentiment remained near historic lows in March. Its NAHB/Wells Fargo Housing Market Index was unchanged from February at 20 -- with any reading under 50 signaling that more builders see conditions as bleak than view them favorably.

The latest signs of economic distress occur against a backdrop of mounting woe in the U.S. financial sector, where the Fed once more stepped in on Sunday night to cut a lending rate to try to keep financial markets from panicking and seizing up.

That came hours after a deal was announced for a takeover of ailing investment bank Bear Stearns by JPMorgan Chase & Co for a bargain-basement price of $2 a share. That deal committed the Fed to fund up to $30 billion of Bear Stearns' less-liquid assets and highlighted a loss of investor confidence in the health of the U.S. financial system.

President George W. Bush, who met his top economic advisers on Monday morning, said afterward the economy faced "challenging times" but played down fears cited by some analysts that it was confronting its worst set of conditions in decades.

"In the long run our economy's going to be fine," said Bush, who leaves office next January and does not want to leave presumed Republican presidential nominee Sen. John McCain in any worse position than necessary when November elections occur. He said the United States was "on top of the situation."

A Treasury Department report showing net overall capital inflows to the United States fell sharply in January underlined the skepticism that foreigners have about the direction of the U.S. economy.

Inflows dropped to $37.4 billion from $72.7 billion in December -- not enough to cover the month's $58.2 billion deficit on trade with the rest of the world and therefore likely to maintain pressure on a steadily sliding U.S. dollar.

The only glimmer of hope came in a report from the Commerce Department showing a modest improvement in the broadest gauge of total U.S. trade with the rest of the world.

Soaring U.S. deficits are cited by academic economists as a root cause of deepening problems in the economy because they reflect the propensity of U.S. consumers to spend rather than save and to borrow endlessly from abroad to finance spending.

The U.S. current account deficit narrowed in the fourth quarter to $172.9 billion from a revised $177.4 billion in the third quarter, the Commerce Department said.

(Additional reporting by Burton Frierson, Pedro Nicolaci da Costa and Gertrude Chavez in New York; Editing by Dan Grebler)