By Burton Frierson
NEW YORK (Reuters) - U.S. manufacturing contracted in May for the fourth consecutive month and inflation pressures surged to their highest in four years, heightening fears the world's largest economy could be sliding toward stagflation.
The Institute for Supply Management report on national factory activity fueled concerns about rising prices in a weak economy, especially after the price of oil hit a record high last month above $135 a barrel.
ISM on Monday said its index rose in May, to 49.6 from April's 48.6, slightly above market expectations. But it remained below the level of 50, signaling contraction.
"These are mildly contractionary readings on manufacturing activity, rather than outright recession signals, although they are accompanied by ugly readings on cost inflation pressures," analysts at Bear Stearns said in a note to clients.
"We think that stagflation remains the dominant theme in the economy and that the consumer and housing, rather than manufacturing, will bear the brunt of the downturn in the economy."
This year's manufacturing downturn is the worst since the five months of ISM contraction in the February-to-June 2003 period and comes as the deepest housing slump since the Depression has weakened the broader economy.
A separate report showed construction spending fell less than expected in April. This added weight to the argument that the economy is weak but may not be in recession.
"DEAD IN LINE"
On Wall Street, benchmark indexes closed down more than 1 percent on the ISM report and fresh concerns about the financial sector. The dollar gained slightly versus the euro but sank against the yen.
U.S. government bonds, which perform better during slow economic times, gave up some ground immediately after the ISM report but subsequently resumed their march higher, helped by weaker stocks.
The contraction in the May ISM index was the fifth in six months. However, the weak dollar has mitigated the damage to the factory sector this year by boosting exports.
The ISM index of new export orders rose to 59.5 -- the highest since May 2004, when it was at 60.0. This was up from April's 57.5.
"This is dead in line with the performance implied by the weakening of the dollar over the past year and will likely persist for a few more months yet," said Ian Shepherdson, chief U.S. economist at High Frequency Economics in Valhalla, New York.
U.S. construction spending fell 0.4 percent in April on continued deterioration in the residential sector, but outside of home building, private spending rose for the third straight month.
Economists polled by Reuters ahead of the Commerce Department's report were expecting a 0.6 percent decrease in construction spending after a 0.6 percent decrease in March that was first reported as a much bigger 1.1 percent decline.
The factory sector also struggled across the Atlantic. Euro zone manufacturing activity cooled more in May as output remained at a near-three-year low.
The RBS/NTC Eurozone Purchasing Managers Index for the manufacturing sector eased to 50.6 in May, down from April's 50.7 but above the earlier estimate of 50.5, which was also the median number forecast by economists.
The U.S. ISM report showed a worrying trend for inflation, with its index of prices paid jumping to 87.0 -- the highest since April 2004 -- from 84.5 in April.
Inflation was also a concern in Europe. Sky-high fuel and food prices put a damper on finance ministers' celebration in Frankfurt of the European Central Bank's 10th birthday, a milestone in Europe's monetary union.
ECB chief Jean-Claude Trichet set the tone, warning that bad management of the oil crisis in the 1970s -- meaning large wage rises and low interest rates -- seriously hurt the economy and jobs, and that the errors of the past must not be repeated.
(Additional reporting by Joanne Morrison; Editing by Dan Grebler)