Inflation flare-up mars factory rebound

NEW YORK (Reuters) - Manufacturing expanded in June for the first time in five months, helped by a weak dollar, but inflation pressures soared to their highest level since the stagflation-ravaged 1970s, according to a report that highlighted the bind facing policy-makers.

A separate report on Tuesday by the government showed U.S. construction spending fell 0.4 percent in May as homebuilding continued to deteriorate. The data adds to concerns the United States is in a period of weak growth accompanied by high inflation.

"It paints a slowing-growth scenario with rising inflation. That's a tough path for the Fed to traverse," said George Adell, fixed-income strategist at Commerce Capital Markets in Jupiter, Florida.

U.S. auto sales plunged in June, but a month-end clearance sale helped General Motors Corp GM.N retain its No. 1 spot and steer clear of the wipeout many had feared, driving its shares up.

The Institute for Supply Management said its index of national factory activity rose in June to 50.2, topping the 50 level that marks expansion for the first time since January.

Economists attributed the increase to a weak dollar, which helps exports, and some restocking of inventories.

While the index was just above forecasts and May's reading of 49.6, the report also showed manufacturers are slashing jobs while being pinched by soaring prices and weak demand.

Federal Reserve officials will pay particular attention to the prices paid gauge of inflation, which jumped to the highest level since July 1979.

"Prices are downright ugly," said Adell.

The U.S. central bank has slashed interest rates to combat an economic downturn led by the worst housing slump since the Depression of the 1930s. While the Fed has been seeking to promote growth, critics say policy-makers should focus on inflation by raising rates.

On Wall Street, the ISM report momentarily boosted stocks, and equities managed to close higher at the end of a volatile day, driven higher after GM released its sales figures. The dollar benefited briefly, but it was last down slightly versus the euro. Safe-haven government bonds were slightly lower.

PRICE INCREASES

This year's manufacturing slump was the worst since 2003, when the ISM index spent five consecutive months below 50, from February to June that year. However, the index did not reach the low-40s depths hit during the recession of 2001.

The recent slide in factory activity has been mitigated by a sharp dollar decline, which has kept U.S.-made goods more competitive abroad than they might have been otherwise.

As evidence of this, the ISM's gauge of new export orders held near May's four-and-a-half-year high last month.

Still, June's rebound was slight and economists cautioned that it by no means signaled an extended expansion.

Economists' median forecast was for an ISM reading of 48.6, according to a Reuters poll. The 81 forecasts in the survey ranged from 46.0 to 50.5.

The ISM index of prices paid jumped to 91.5 from 87.0 in May, and there were worrying signs that manufacturers were passing on their higher prices.

"I'm seeing evidence in the market that the magnitude of the increases is so large that people can't help themselves," said Norbert Ore, head of the Institute for Supply Management's Business Survey Committee.

"Most of those companies are adamant that they have to have the price increase in order to stay in business," he added. "Generally they are very successful in trying to pass that on to customers. The thought of trying to offset that with productivity couldn't be done."

The ISM employment index fell to 43.7 in June from 45.5 in May, its lowest since May 2003, offering a hint at Thursday's national employment report.

Although U.S. construction spending slid overall in May due to the dismal residential sector, outside of home building, private spending rose for the fifth consecutive month.

On the retail front, U.S. chain store sales rose 0.1 percent in the June 28 week, versus a 0.6 percent decrease the prior week, according to the International Council of Shopping Centers and UBS Securities.

Chain store sales rose 2.2 percent in the June 28 week year-on-year versus the prior week's 2.2 percent gain, they said.

(Editing by Leslie Adler)