WASHINGTON - A government report released yesterday showing unexpected vigor in the homebuilding industry in August bolstered expectations that the economy is strengthening.

The Commerce Department said housing starts surged 7.8% last month to a seasonally adjusted annual rate of 1.32 million units, the highest level in three and a half years. Healthy gains were recorded in all regions of the country except the Northeast, where starts fell.

The increase in building activity followed a revised drop of 1.7% in July starts. The July drop, which apparently reflected wet weather and flooding in the Midwest, was concentrated in single-family homes. In August, starts of single-family homes soared 11% to 1.18 million units, the highest level since September 1987.

While the housing industry has shown some Improvement this year with the help of lower mortgage interest rates, some economists have found the recovery disappointingly mild. The August figures suggested that lower rates are starting to spur more demand from buyers even though the job markets remain sluggish and consumer confidence is low, analysts said.

"I think you're finally getting some burst from the recent declines in mortgage rates to the lowest level in over two decades," said David Cohen, an economist with MMS International, a forecasting firm for fixed-income firms. "All the textbooks say you should get some increase in demand."

Cohen said the bond market began to anticipate a strong report on housing starts after the National Association of Home Builders on Monday said 44% of the builders in its weekly survey for early September called single-family home sales "good." That was the highest reading since before the recession.

The builders association's surveys also showed builders are seeing increased traffic among potential home buyers, as well as optimism about sales over the next six months.

In addition, the weekly figures for mortgage loan applications from the Mortgage Bankers Association have been running hot. Roughly half of such applications are for re-financings, and the rest for purchases of new and existing purchases.

"The fundamentals are in place, so that, if anything, the housing sector is going to accelerate as we go through the balance of the year." said Brian Jones, an economist at Salomon Brothers. "The number of people out there looking has been flying, and with these rates, it should be."

The average rate f6r 30-year fixed-rate mortgages fell to 6.97% at the end of August, the lowest in 25 years, according to the Federal Home Loan Mortgage Corp. Since then, rates have edged up slightly on expectations of improved economic performance.

While the August housing starts figures may overstate the strength of the industry, "it makes us feel a lot more comfortable that we're going to get somewhere between 2 1/2 and 3% growth in the final six months of the year," said Jones. "One of the things we're looking for in our forecast is a sharp pickup in residential investment, so this jibes with that, and we feel better about the numbers that we're looking for over the balance of the year."

Douglas Schindenwolf, chief economist for Smith Barney Harris Upham & Co., said the housing figures represented "a little bit-of-a catch-up from the data earlier in the year."

Schindenwolf said that the housing report had to be balanced against recent statistics on employment, merchandise trade, and retail sales, which have been on the weak side. "Today's report sort of brought us back to the center, and we think the center means about 2.5% growth, which we think is the underlying rate in the economy." he said. The Commerce Department also said that housing permits, a barometer of future building activity, jumped 7.5% in August to 1.25 million units, the highest level since September, 1987. Permits for single-family homes raise a solid 3.7% to 1.01 million, the highest since February, 1990.

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