By Burton Frierson
NEW YORK (Reuters) - Factory activity contracted again in March while prices paid by manufacturers rose to their highest in more than two years, according to data on Tuesday that suggested faster inflation in a stagnating economy.
A separate report also showed construction spending in February fell for a fifth month as the nation's housing industry remained mired in a historic downturn.
Even so, stocks surged for a second session on Tuesday after the manufacturing and construction reports, both of which showed the sectors had contracted less than expected. That raised hopes that the worst may soon be over for an economy that many believe has entered recession.
"It is showing that activity has certainly slowed but it is not as dire a report as it possibly could have been," Georges Yared, chief investment strategist at Yared Investment Research in Wayzata, Minnesota, said about the manufacturing report. "The end of the world is not here."
U.S. construction spending fell 0.3 percent in February, hitting the lowest annual rate since mid-2005, the Commerce Department said.
The bad news on manufacturing came from the Institute for Supply Management, whose index of national factory activity edged up to 48.6 in March from 48.3 in February, but remained below the level of 50 that separates growth from contraction.
The indication of worsening inflation came from the ISM's prices paid index, which jumped to 83.5 in March -- its highest since October 2005, when disruptions caused by Hurricane Katrina led gasoline prices to rise sharply.
The prices paid index at 75.5 in February.
"The March ISM index confirms that the manufacturing is in a recession that we believe started back in October 2007," said Daniel J. Meckstroth, chief economist for the Manufacturers Alliance/MAPI, an economic and public policy research group.
"The combination of declining business activity and rising prices brings back the unpleasant memories of yesteryear's stagflation."
It was the third time in four months the gauge has shown contraction.
Wall Street cheered the manufacturing report, however, since the main index reading came out higher than the 47.5 foreseen in a Reuters poll of economists.
The dollar also extended its gains against the euro and yen after the ISM data. Prices on government bonds, which are generally hurt by inflation and economic strength, fell sharply.
In a sign that the manufacturing sector's fortunes may be worsening, the new orders index slipped to 46.5 in March -- its lowest since October 2001, when the economy was still mired in recession -- from 49.1 in February.
New orders were probably not helped by a strike at American Axle & Manufacturing Holdings Inc
Meanwhile, the report on construction spending showed the worst housing downturn in a generation was spreading its fallout.
Private home building fell to a $456.9 billion rate in February, the lowest since May 2003. This sector has fallen for 24 consecutive months since a peak in home building two years ago.
(Editing by Frank McGurty)