Sept. 19 (Bloomberg) -- Housing construction in the U.S. declined more than forecast last month to the lowest level in three years as waning demand left builders with a growing number of unsold homes.

The 6 percent decrease in housing starts to an annual rate of 1.665 million followed a 1.772 million pace in July, the Commerce Department said today in Washington. Building permits dropped for a seventh straight month to the lowest level in four years and a sign home construction will keep slowing.

The battered U.S. housing market poses a risk of a larger slowdown in the economy and reinforces economist forecasts that Federal Reserve policy makers tomorrow will keep interest rates unchanged for a second month. Producer prices rose less than forecast last month, suggesting inflation is cooling along with economic growth, a Labor Department report showed today.

``There's no doubt the housing market is declining and we expect it to continue to decline through most of 2007,'' said Phillip Neuhart, an economist at Wachovia Corp. in Charlotte, North Carolina. ``Combined with the PPI data, it really sits with the Fed-on-hold scenario.''

Prices paid to producers rose 0.1 percent for a second month in August, the Labor Department said. Economists surveyed by Bloomberg News expected a 0.3 percent rise. Excluding food and energy, the core rate unexpectedly fell 0.4 percent after a 0.3 percent decrease. The back-to-back declines were the first since the end of 2002.

The benchmark 10-year Treasury note rose 9/32, pushing down the yield almost 4 basis points to 4.77 percent at 8:48 a.m. in New York. The dollar fell against the yen and was little changed against the euro.

Economist Forecast

Economists expected starts to fall to an annual rate of 1.746 million units from an originally reported 1.795 million pace in July, according to the median of 68 forecasts in a Bloomberg survey. Estimates ranged from 1.62 million to 1.85 million.

Starts, which are down almost 24 percent from a year earlier, have fallen for three straight months. The August level was the lowest since 1.643 million in April 2003.

Building permits dropped to an annual rate of 1.722 million from 1.763 million the prior month. Not since May to November 1986 have permits declined seven straight months.

Sales dropped in July and inventories of unsold new homes rose to a record, the Commerce Department said on Aug. 24, leaving builders with little choice but to build less and offer incentives to spur demand.

Single-Family Homes

New construction of single-family homes declined 5.9 percent in August to a 1.36 million rate, the slowest since February 2003. New construction of multifamily homes, such as townhouses and apartment buildings, fell 6.7 percent to an annual rate of 305,000.

Starts fell in all regions but the Northeast. They decreased 12 percent in the Midwest to 267,000, the lowest since December 2000; 6.1 percent in the South to an 833,000 pace; and 5.5 percent in the West to 410,000. Starts rose 5.4 percent in the Northeast to a 155,000 pace.

The number of homes under construction dropped 1 percent in August to a 1.346 million pace. Housing completions fell 3.2 percent to an annual rate of 1.868 million.

The number of housing units authorized, but not yet started, increased 3.4 percent to 225,100.

Wells Fargo & Co. Chief Executive Officer Richard Kovacevich said yesterday that the housing market is probably weaker than economic data suggest because homebuilders are using ``very significant incentives'' to attract buyers.

Inventories Rise

``We will see over the next five to six months inventories increase quite substantially'' as that strategy becomes less successful in tempering the decline in demand for new homes, Kovacevich, whose bank is the second-biggest U.S. mortgage lender, said at a conference in San Francisco.

Builder confidence is suffering. The National Association of Home Builders/Wells Fargo said yesterday that its index of builder optimism fell this month to the lowest level in 15 years. The Standard and Poor's 500 Homebuilding Index, made up of five of the largest U.S. builders, has fallen by more than a quarter this year, the second-worst performance among S&P 500 industry groups.

Lennar Corp., the second-largest U.S. homebuilder by market value, on Sept. 8 said profit fell in the fiscal third quarter for the first time in six years.

`Continued to Deteriorate'

``The U.S. housing market has continued to deteriorate,'' Stuart Miller, Lennar's president and chief executive officer, said in a statement. ``Given difficult market conditions, we have limited our land purchases while we have remained focused on even flow production and minimizing completed inventory.''

Housing starts this year may decline almost 10 percent, according to a National Association of Realtors forecast issued Sept. 7. Home sales will probably drop 8 percent this year and another 2 percent next, the group said.

Median existing home prices will rise 2.8 percent this year to $225,900 after rising 10.5 percent in 2005, the Realtors forecast. Home prices in some months this year may dip below year- ago levels, the Realtors forecast.

The group's measure of housing affordability fell in July to its lowest level since 1989 as mortgage rates increased and home prices edged up.

Second Quarter

Home construction in the second quarter subtracted more from economic growth than at any time since the first three months of 1991, according to the Commerce Department. The slowdown in the real estate market is also producing smaller gains in home prices that may remove a source of strength for consumer spending as fewer home owners refinance.

Economic growth will average an annual rate of 2.7 percent in the second half of this year, compared with a 4.25 percent pace in January through June, according to the median forecast of economists surveyed by Bloomberg earlier this month.

All of the 107 economists surveyed predict Fed policy makers will keep their target rate for overnight lending between banks at 5.25 percent when they meet tomorrow.

The effects of the Fed's 17 straight interest rate increases between June 2004 and June 2006 are ``still playing out'' in the economy, Kansas City Fed Bank President Thomas Hoenig said at a speech to bankers in Copper Mountain, Colorado, on Sept. 15. The housing market's slowdown is ``significant,'' Hoenig said. Slower economic growth ``would be healthy and that would allow inflation to continue to moderate over the course of the outlook,'' he said.

To contact the reporter on this story: Bob Willis in Washington bwillis@bloomberg.net

Last Updated: September 19, 2006 08:52 EDT