By Lucia Mutikani
WASHINGTON (Reuters) - U.S. factory activity slowed in January amid a fall in new orders, but an unexpected drop in the number of Americans filing for unemployment benefits last week pointed to sustained labor market strength that should underpin domestic demand.
The economy's healthy fundamentals were also underscored by other data on Thursday showing a solid increase in construction spending in December. A decline in worker productivity in the fourth quarter, however, suggested it may be hard to maintain the strong pace of economic growth.
The Federal Reserve on Wednesday described the labor market as having "continued to strengthen," and economic activity as "rising at a solid rate." The U.S. central bank left its benchmark overnight interest rate unchanged. U.S. financial markets are expecting a rate hike in March.
"The demand is there, but manufacturers are struggling to keep up," said Jennifer Lee, a senior economist at BMO Capital Markets in Toronto.
The Institute for Supply Management (ISM) said its index of national factory activity fell to a reading of 59.1 last month from 59.3 in December. A reading above 50 in the ISM index indicates growth in manufacturing, which accounts for about 12 percent of the U.S. economy.
The survey's production and employment sub-indexes fell in January as did a gauge of new orders. The moderation in orders is likely to be temporary against the backdrop of strong domestic and global demand.
Manufacturers reported an increase in export orders and most offered an upbeat assessment of business conditions.
Manufacturers of computer and electronic products said "budgets are being approved for new projects." Furniture manufacturers reported that "our usual winter slowdown has not occurred, and we are very busy with new orders."
Domestic demand increased at its fastest pace in more than three years in the fourth quarter. A weak dollar, which lost 7 percent of its value against the currencies of the United States' main trading partners last year, is making U.S.-made goods more competitive on the international market.
The ISM survey also showed signs of a pickup in inflation, with a measure of prices paid by factories for raw materials increasing to its highest level since May 2011.
U.S. Treasury yields rose while the dollar (DXY) fell against a basket of currencies. Stocks on Wall Street were trading higher.
NEAR FULL EMPLOYMENT
In a separate report, the Labor Department said initial claims for state unemployment benefits slipped 1,000 to a seasonally adjusted 230,000 for the week ended Jan. 27. Economists polled by Reuters had forecast claims rising to 238,000 in the latest week.
Last week marked the 152nd straight week that claims remained below the 300,000 threshold, which is associated with a strong labor market. That is the longest such stretch since 1970, when the labor market was much smaller.
"The untapped reservoir of unemployed or underemployed skilled workers that existed in the aftermath of the recession has largely disappeared," said Jim Baird, chief investment officer at Plante Moran Financial Advisors in Kalamazoo, Michigan. "Employers are finding it more difficult to find potential workers."
The labor market is near full employment, with the jobless rate at a 17-year low of 4.1 percent. A tightening of labor market conditions has raised optimism among Fed officials that inflation will rise toward the U.S. central bank's 2 percent target this year.
The claims data has no bearing on January's employment report, which is scheduled to be released on Friday, as it falls outside the survey period. According to a Reuters survey of economists, nonfarm payrolls probably rose by 180,000 jobs in January after increasing by 148,000 in December.
Skilled worker shortages and weak productivity could put pressure on companies seeking to expand their businesses, economists say. That could spur corporate investments in automation to increase efficiency and output, according to Plante Moran Financial Advisors' Baird.
In a third report on Thursday, the Labor Department said nonfarm productivity, which measures hourly output per worker, fell at a 0.1 percent annualized rate in the fourth quarter.
That was the first drop and weakest performance since the first quarter of 2016 and followed a 2.7 percent pace of increase in the third quarter.
Compared to the fourth quarter of 2016, productivity increased at a rate of 1.1 percent. It rose 1.2 percent in 2017, the fastest since 2015, after dipping 0.1 percent in 2016.
Soft productivity suggests it would be hard for the economy to hit the Trump administration's 3 percent annual growth target even with the $1.5 trillion tax cut package passed by Congress in December. Gross domestic product rose 2.3 percent in 2017.
"Weak productivity and slowing population growth is not a recipe for success when it comes to the story of sustainable economic growth of 3 percent in coming years," said Chris Rupkey chief economist at MUFG in New York.
"It is looking more and more that the productivity trend will make it impossible for those $1.5 trillion of tax cuts to be paid for by faster economic growth that improves incomes and leads to greater tax revenues."Unit labor costs, the price of labor per single unit of output, rose at a pace of 2.0 percent in the final three months of 2017 after slipping at a rate of 0.1 percent in the third quarter. They gained 0.2 percent in 2017, the smallest increase since 2010, after rising 1.1 percent in 2016.
A fourth report from the Commerce Department on Thursday showed construction spending rose 0.7 percent to an all-time high of $1.25 trillion. It advanced 2.6 percent on a year-on-year basis.