* Producer prices up 0.2 pct, first increase in 4 months

(Updates markets to close)

By Lucia Mutikani

WASHINGTON (Reuters) - U.S. home building increased
at a much weaker pace than expected in July, though sturdy
growth in industrial output implied the embattled economy has
enough strength to keep growing.

Tuesday's mixed batch of data also showed a tick up in
producer inflation last month, which some analysts said helped
ease concerns of a damaging downward spiral of falling prices
amid an ebb in momentum in recovery from the longest and
deepest downturn since the 1930s.

Worries of deflation and a double-dip recession have
dominated investor sentiment in recent weeks, but economists
generally believe the fears are being overplayed.

"The data don't suggest that we are heading for a
double-dip, the data do confirm that we are in a very subdued
recovery. We continue to have a mixed picture with other
sectors lagging and others leading," said Julia Coronado, an
economist at BNP Paribas in New York.

Weak homebuilding data provided a bleak backdrop for a
closely watched conference of housing experts hosted by U.S.
Treasury Secretary Timothy Geithner to discuss how to
restructure the mortgage financing sector.

The consensus seemed to be that the government must have
some role in ensuring would-be homeowners can get money to buy
houses so that the hard-hit housing industry can recover.

Housing starts rose 1.7 percent to a seasonally adjusted
annual rate of 546,000 units, the Commerce Department said, but
below market expectations for a 560,000-unit pace.

New building permits, which give a sense of future home
construction, dropped 3.1 percent to a 565,000-unit pace last
month, the lowest level since May 2009. Financial markets had
expected a 580,000-unit rate.

Separately, industrial output jumped 1 percent last month
after slipping 0.1 percent in June, the Federal Reserve said.

On the inflation front, prices paid at the farm and factory
gate rose 0.2 percent in July for their first advance in four
months, while core producer prices excluding food and energy
increased 0.3 percent, other government data showed.

DEFLATION FEARS SUBSIDE

Against the the backdrop of growing deflation talk,
analysts welcomed the rise in core PPI.

"Core pipeline price pressures are gradually building
across most consumer-related sectors," said Peter Newland, an
economist ay Barclays Capital in New York.

"This supports our view that the chances of a period of
outright deflation in core consumer prices remain slim despite
the apparent loss of momentum in the broader recovery."

Stocks on Wall Street brushed aside the mixed economic
data, with all three indexes ending firmly higher after
bellwether retailers Wal-Mart Stores Inc and Home Depot
Inc recorded better-than-expected profits. But Wal-Mart
warned the U.S. consumer remained under pressure.

"The slow economic recovery will continue to affect our
customers, and we expect they will remain cautious about
spending," Wal-Mart Chief Executive Mike Duke said.

Prices for U.S. government debt fell on easing fears of
deflation and also after Monday's hefty gains that pushed
yields to multi-month lows. The U.S. dollar rose against the
Japanese yen.

The slowdown in economic growth is largely a reflection of
the waning of some government stimulus programs, including a
popular homebuyer tax credit.

The end of the tax credit in April has left a void in the
housing market, depressing sales and building activity.
Sentiment among home builders touched a 17-month low in August,
a survey showed on Monday.

Geithner told the conference there was a strong case for a
carefully designed government guarantee for mortgages.

"Without such support, the risk is that future recessions
could be more severe because the financial system would not
have the capital to support mortgage lending on an adequate
scale," Geithner said. "House price declines could be more
acute, with even greater damage to financial wealth."

While housing starts increased overall last month, this
reflected a 32.6 percent surge in groundbreaking activity in
the volatile multifamily segment. Single-family homes starts
fell 4.2 percent to their lowest level since since May 2009.

Home completions and the number of homes under construction
were the lowest on record last month.

The industrial production report, though, confirmed the
strength in manufacturing remained.

Last month's rise in industrial output was double what
markets had expected and gains were across the board, with
automotive products surging nearly 9 percent.

Capacity utilization, a measure of how fully firms are
employing their resources and a key benchmark for monetary
policy, rose to 74.8 percent, the highest since September 2008,
when the financial crisis was raging.
(Additional reporting by Doug Palmer and Pedro Nicolaci da
Costa; Editing by Chizu Nomiyama)