WASHINGTON (Reuters) - Housing starts hit a five-month low in May as a homebuyer tax credit expired while wholesale prices remained subdued, giving the Federal Reserve ample room to maintain its ultra-low interest rate policy.

The weak housing market data released by the Commerce Department on Wednesday contrasted with a separate report from the Fed that showed a surge in industrial output, highlighting the uneven nature of the economic recovery.

“It seems clear that the housing market hasn’t recovered very much, except for the amount induced by policy over the last year. That’s the main reason why GDP growth overall remains somewhat sluggish,” said Zach Pandl, a U.S. economist at Nomura Securities International in New York.

The housing data was the latest to suggest the recovery from the worst recession since the 1930s appears to have lost some momentum in May. Economists say a renewed downturn is unlikely.

New home building fell 10 percent to an annual rate of 593,000 units, the lowest since December. A rise in mortgage purchase applications last week after five straight declines offered hope the post-tax credit falloff would be temporary.

In contrast to the housing weakness, industrial output surged 1.2 percent, partly due to a spike in utility production as rising temperatures prompted Americans to turn on air conditioners. Still, factory output rose a solid 0.9 percent.

The dour housing starts report and a warning from FedEx Corp FDX.N that costs related to pensions and retiree medical costs would hit its 2011 profits initially pushed stocks on Wall Street lower. However, key U.S. stock indices ended flat.

Prices for U.S. government debt rose, while fresh worries about Spain’s credit and banking system lifted the dollar from a two-week low versus the euro.

While the manufacturing recovery appeared on track, there were few signs of price pressures at the production level.

The producer price index, a gauge of prices received by farms, factories and refineries, fell 0.3 percent last month as gasoline costs tumbled, the Labor Department said.

Core producer prices, which exclude food and energy costs, rose only 0.2 percent for a second straight month.

Other data have shown private hiring slowed sharply in May and retail sales fell. However, employers increased working hours and sales at some retailers held up.

Construction workers continue work on a new subdivision of homes in San Marcos, California April 23, 2010. REUTERS/Mike Blake

ECONOMIC SLACK LESSENS

The steady factory recovery and surge in utility output pushed industries to employ 74.7 percent of their productive capacity last month, the Fed’s report showed.

While that measure of economic slack was up 1 percentage point from April and at its highest level since October 2008, it was still 5.9 points below its average from 1972 to 2009, suggesting inflationary bottlenecks were far from building.

The benign inflation picture and worries the sovereign debt crisis in Europe could shave a bit off U.S. growth, should allow the Fed to renew its commitment to low interest rates at a meeting next week.

Most economists do not expect the U.S. central bank to raise overnight interest rates from their current level near zero until some time next year.

“The Fed has historically not tightened before capacity utilization is at or near 78 (percent) and usually nearer to 80,” said Alan Ruskin, head of currency strategy at RBS in Stamford, Connecticut. “Even with manufacturing leading the recovery, this indicator is some way away from flashing red to the Fed that they must tighten.”

While the economy has grown for three straight quarters, it has lacked vigor. Anxiety over the recovery pace has eroded President Barack Obama’s popularity and could cost the Democratic Party dearly in November mid-term elections.

The fall in housing starts in May was the biggest in 14 months and well below the 650,000 units expected by analysts.

New building permits, which give a sense of future home construction, dropped 5.9 percent to a 574,000-unit pace, the lowest in a year. That followed a 10.9 percent drop in April and compared to expectations for a rise to 630,000 units.

Starts on single-family homes fell 17.2 percent to a 468,000 unit rate, with permits down 9.9 percent to a 438,000 unit pace. Both were the lowest in a year.

“We think that rising employment will lead to a gradual improvement in housing activity over the second half of the year,” said Nigel Gault, chief U.S. Economist at IHS Global Insight in Lexington, Massachusetts. “But the second successive monthly decline in single-family housing permits indicates the payback (from the tax credit) has further to run first.”

Analysts said while mortgage rates and home prices were low, an oversupply of houses on the market was weighing on construction.

However, demand for home loans bounced back from 13-year lows last week, with mortgage purchase applications rising 7.3 percent, the Mortgage Bankers Association said.