By Lucia Mutikani
WASHINGTON (Reuters) - Consumer spending was tepid in January as higher taxes squeezed incomes, but vigor in the manufacturing sector last month suggested economic growth picked up early this quarter.
Other data on Friday showed strong auto sales and a rise in consumer sentiment in February, which should help support spending.
The reports suggested the economy had enough momentum to withstand the $85 billion in federal budget cuts known as the "sequester" that were set to start taking hold on Friday, but not so much as to convince the Federal Reserve to decrease its monetary support for the recovery.
"The numbers say the economy does have a reasonable amount of momentum that is probably enough to deal with whatever comes from the sequestration," said Bill Cheney, chief economist at John Hancock Financial Services in Boston.
Consumer spending, which accounts for about 70 percent of U.S. economic activity, increased 0.2 percent in January, the Commerce Department said. The increase was driven by spending on utilities after a cold snap.
After adjusting for inflation, spending was up just 0.1 percent.
In a separate report, the Institute for Supply Management said its index of national factory activity rose to 54.2 in February on strong orders growth. It was the highest level since June 2011 and followed as reading of 53.1 in January.
A reading above 50 indicates expansion in manufacturing and the rise bucked the global trend, where factories in the euro zone were mired in weakness and activity in China slowed.
The report suggested manufacturing will continue to support U.S. growth, a welcome sign as consumer spending is expected to pull back sharply this quarter due to higher taxes.
"We expect a significant decrease in real consumer spending in the first half of the year," said Yelena Shulyatyeva, a U.S. economist at BNP Paribas in New York.
Shulyatyeva said she expects the economy to advance at a meager 1.2 percent annual rate in the first quarter. In the final three months of last year, it rose at a 0.1 percent pace, even as consumer spending rose at a healthy 2.1 percent rate.
U.S. stocks closed higher on the factory and confidence reports, while the dollar hit a six-month high against a basket of currencies. U.S. Treasury debt prices rose on worries that the automatic government spending cuts would dent growth.
The International Monetary Fund said on Thursday that the cuts, if fully implemented, could shave at least half a percentage point from growth this year.
TAXES ERODE INCOMES
The pressure on spending from the expiration of a 2 percent payroll tax cut and higher tax rates for wealthy Americans is expected to be even larger in February and possibly extend through the first half of the year.
But there is reason to be cautiously optimistic.
U.S. auto sales rose nearly 4 percent in February and were above a 15-million unit annual rate for a fourth straight month, the first time this has happened since early 2008.
In addition, the Thomson Reuters/University of Michigan's consumer sentiment index rose to 77.6 in February from 73.8 in January, amid optimism over jobs.
Steady job growth should help support spending, given that income tumbled 3.6 percent in January, the largest drop since January 1993. Part of the decline was payback for a 2.6 percent surge in December as businesses rushed to pay dividends and bonuses before taxes moved higher.
Taking taxes into account, income plunged a record 4.0 percent in January after advancing 2.7 percent in December.
With income dropping sharply, consumers put a brake on their spending to pay their bills. The saving rate - the percentage of disposable income households are socking away - fell to 2.4 percent, the lowest level since November 2007. The rate had jumped to 6.4 percent in December.
The report showed inflation under wraps with a price index for consumer spending flat for a second straight month and a core reading that strips out food and energy costs up just 0.1 percent.
Over the past 12 months, inflation has risen just 1.2 percent, the smallest gain since October 2009 and a slowdown from the 1.4 percent logged in the period through December.
Core prices are up 1.3 percent, the smallest rise since April 2011 and well below the Fed's 2 percent target.
The lack of inflation should come as welcome relief for American households, but it could cause some nervousness at the U.S. central bank, which may see it as a symptom of the economy's weakness.
In testimony to Congress this week, Fed Chairman Ben Bernanke signaled that the central bank would press forward with plans to buy $85 billion in bonds per month.
"The poor performance in real spending activity will continue to augur for more policy accommodation as they try to provide a monetary offset for the expected fiscal drag, which should accelerate in the second quarter," said Millan Mulraine, a senior economist at TD Securities in New York.
(Additional reporting by Richard Leong and Leah Schnurr in New York; editing by Andrea Ricci)