By Lucia Mutikani
WASHINGTON (Reuters) - Consumers struggled to make ends meet in August as incomes fell for the first time in nearly two years, while a surge in Midwest manufacturing this month provided one bright spot in an otherwise weak economy.
Spending, the major driver of U.S. growth, was flat when adjusted for inflation last month as consumers grappled with falling incomes, Commerce Department data showed on Friday. Incomes fell 0.1 percent, the first drop since October 2009.
But the sting from the weak spending report was softened by the strength in manufacturing in the Midwest in September and news that consumers grew more optimistic as the month ended.
"While the economy is not growing quickly, neither is it falling off the table and that matters because markets have already priced in a recession," said John Canally, economist at LPL Financial in Boston.
Consumer spending accounts for about 70 percent of U.S. economic activity and has softened all year, so the flat inflation-adjusted reading for spending in August added to a picture of shaky GDP growth. Spending rose 0.2 percent without accounting for inflation.
Poor household finances are hurting profits at some major consumer product companies, such as Best Buy where customers are steering clear of big-ticket items.
"We're still facing an uncertain macro environment with volatile consumer shopping behavior," Best Buy chief executive officer Brian Dunn said earlier this week.
The data on Friday had little impact on U.S. financial markets, with stocks on Wall Street falling as investors worried a contraction in China's manufacturing could deepen the slowdown in the global economy.
Prices for U.S. government bonds rallied sharply, while the dollar rose against a basket of major currencies, largely on risk aversion.
Although the nation's manufacturing, which has shouldered the recovery, is cooling nationwide, it is doing so at a less rapid pace and showed surprising strength in the Midwest. Businesses continue to invest in machinery, which should help the economy to skirt a new recession.
The Institute for Supply Management-Chicago's business barometer rose to 60.4 from 56.5 in August. Economists had expected it to decline to 55.5. A reading above 50 indicates expansion in the regional economy.
That suggests a modest slowdown in national factory activity, when the Institute for Supply Management on Monday releases its September survey of national manufacturing.
SAVINGS TO THE RESCUE
With the economy failing to create jobs in August, Americans turned to their savings to fund purchases.
Incomes are also being stretched to cover rocketing health insurance costs. A Kaiser Family Foundation survey this week found annual family premiums this year growing at a pace triple that of 2010.
Savings last month fell to their lowest level since December 2009. Economists said it was unlikely households would continue to draw down on their savings to keeping spending.
"It seems very unlikely that consumers can lead the economy to a faster recovery pace. The consumer needs job growth," said John Ryding, chief economist at RDQ Economics in New York.
"Higher inflation continues to hurt consumers as price increases outstrip gains in wage incomes."
The income report showed year-over-year inflation pressures still elevated, with the personal consumption expenditures price (PCE) index rising 2.9 percent, the largest gain since October 2008, after advancing 2.8 percent in July.
The core index, which is closely watched by Federal Reserve officials, increased 1.6 percent in the 12 months through August after rising by the same margin in July.
The Fed last week announced a new measure designed to push long-term borrowing costs lower by shifting assets on its balance sheet in an effort to stimulate growth.
Fed Chairman Ben Bernanke said this week the U.S. central bank might need to ease monetary policy further if inflation or inflation expectations fell significantly.
"Higher inflation is being ignored by the Fed. Without job growth there is no income power, and without income power higher inflation erodes the prospects for stronger growth," said Eric Green, chief economist at TD Securities in New York.
GLIMMERS OF HOPE
But there is hope that consumers will not retrench completely after confidence improved this month.
The Thomson Reuters/University of Michigan's final reading of the overall index on consumer sentiment stood at 59.4, up from 57.8 earlier this month.
Economists had expected no change from the initial September reading. The index finished at 55.7 in August.
There was also good news in the Chicago ISM, with a gauge of employment jumping to 60.6 from 52.1 in August.
Despite the rise in the Chicago ISM, which showed a strong increase in new orders, some manufacturers are pulling back.
Industrial conglomerate Ingersoll Rand Plc was the latest, cutting its third-quarter and full-year earnings forecast to below market estimates, citing weak demand at its key North American residential and commercial markets for security technology.
(Additional reporting by Ann Saphir in Chicago and Richard Leong in New York; Editing by Andrea Ricci)