NEW YORK (CNN/Money) - Manufacturing activity grew in the United States in March, the government said Monday, the second straight month of expansion following an 18-month slump and the latest sign that the broader economy is recovering from its own recession.

The Institute of Supply Management (ISM), formerly known as the National Association of Purchasing Management, whose members buy materials for the nation's biggest companies, said its key gauge of manufacturing activity rose to 55.6 in March from 54.7 in February.

It was the highest reading for the index since 55.8 in March 2000. Any reading below 50 indicates contraction.

"The March report certainly validates the turnaround for manufacturing," said ISM survey committee chairman Norbert Ore. "While the growth in production slowed, new orders rose to a very lofty level, in fact, reaching a level last seen in October 1986. It is encouraging that the rate of decline in employment is slowing and that a number of businesses indicated that they are starting to rehire."

Separately, the Commerce Department said spending on construction projects rose 1.1 percent to an annual rate of $879.4 billion in February after rising a revised 0.8 percent in January. Economists surveyed by Briefing.com expected construction spending to rise 0.8 percent.

U.S. stock prices extended earlier losses after the reports, but recovered somewhat and were mixed in afternoon trading. Treasury bond prices fell.

ISM's index of new orders rose to 65.3 in March, its highest level since 1986, from 62.8 in February. Its production index slipped to 57.8 from 61.2, but its employment index rose to 47.5 from 43.8. In other words, though the sector is still losing jobs, the pace of the cuts has slowed.

ISM's price index posted a 10 percent gain to 51.9 from 41.5, a development that could raise inflation concerns, though it's likely still too early to start sounding alarms.

"While the [price] index was up, the list of commodities up in price is quite small, suggesting it is too early in the recovery to worry about inflation as a result of pricing moves," Ore said.

To keep consumers spending and set the stage for recovery from a recession that might have begun in March 2001, the Federal Reserve cut its target for short-term interest rates 11 times in 2001. With rates at 40-year lows, the Fed decided at its first two policy meetings in 2002 to leave rates alone.

At its latest meeting, the Fed said the risks to the economy were balanced between a risk of inflation and a risk of further economic weakness. Some observers think the Fed will start raising short-term rates as soon as its May 7 meeting if the economy shows signs of growing out of control and fueling inflation.

"With [manufacturing] activity clearly accelerating...it is hard to see [Monday's ISM] report as anything but bad news for Treasuries and yet more evidence of the need for tighter policy," said Ian Shepherdson, chief U.S. economist at High Frequency Economics Ltd.

Related links       ISM report Construction spending report CNN/Money economic calendar Special Report: Eyes on the Fed

Most economists still think inflation is a distant threat, but they are ratcheting up their expectations for economic growth. Merrill Lynch chief economist Bruce Steinberg, for example, on Monday raised his forecast for 2002 growth in gross domestic product (GDP) to 3.2 percent from 2.6 percent. GDP, the broadest measure of economic strength, grew a tepid 1.2 percent in 2001, its worst performance since 1991, when it shrank 0.5 percent.

The economy's strength will depend in large part on business spending, Fed Chairman Alan Greenspan and other economists think. A dramatic slowdown in business spending at the end of the late 1990s led to the manufacturing recession and more than a million job cuts and helped fuel the broader recession.

Consumer spending, on the other hand, helped make the recession among the shortest and mildest in U.S. history, boosted by a red-hot housing market. Monday's report on construction spending was further evidence of this scenario. Spending on residential construction rose 2.5 percent in February to $293.4 billion. Non-residential private construction spending, on the other hand, fell 3 percent to $181.9 billion.