U.S. consumers cut spending in September and turned gloomier this month, underscoring the fragile nature of the economy's recovery even as signs emerged that manufacturing activity may be picking up.

The Commerce Department said on Friday that consumer spending fell 0.5 percent last month, the largest drop since December, after a 1.4 percent increase in August. The decline, which was in line with market expectations, followed the end of a government program to boost auto sales.

A separate report showed factory activity in the nation's Midwest expanding for the first time in more than a year, but employment conditions deteriorated. A dismal job market appeared to weigh on consumers, with the Reuters/University of Michigan final index of sentiment for October slipping to 70.6, from 73.5 last month.

U.S. stock indexes briefly pared losses after the manufacturing data, but slipped back to session lows as investors worried about the health of the U.S. consumer.

The irony is consumers are still in a funk even though monthly job losses are shrinking. The economy is in a recovery mode, but it will be a soggy recovery, unless the consumer starts to feel better and spend more, said Cary Leahey, an economist at Decision Economics in New York.

Government data on Thursday showed the economy grew at a 3.5 percent annual rate in the third quarter, probably ending a recession that began in December 2007.

With the labor market still too weak to support domestic demand, there are worries the economy's incipient recovery could wobble once the government support fades.

Consumer spending, which normally accounts for more than two-thirds of U.S. economic activity, had been bolstered by the popular cash for clunkers program, which provided discounts on some new motor vehicle purchases. But that program ended in August, and consumers retrenched last month.

SPENDING SEEN WEAK

Spending adjusted for inflation fell 0.6 percent, the biggest drop since December, after rising 1 percent the prior month, the Commerce Department said. Personal income was flat, but fell for a fourth straight month after adjusting for taxes and inflation.

It sets up a very weak fourth quarter for consumption. It might be around flat to up 1 percent annualized in the fourth quarter, said Ian Morris, chief economist at HSBC Securities in New York.

But if inventories add and you get some rise in business investment, you could get a much more decent fourth-quarter (GDP gain) of around 3 percent, he said.

The factory gauge from the National Association of Purchasing Management-Chicago offered some hope manufacturing activity would help support recovery as businesses stopped paring inventories.

The measure rose to 54.2 in October from 46.1 in September. It was the first time the index had broken above the 50 line that separate contraction from expansion since September 2008. However, an employment subindex slipped further into negative territory.

A report next Friday is expected to show the U.S. unemployment rate rose to 9.9 percent this month from 9.8 percent in September. However, job losses are expected to slow to 175,000 from the 263,000 there were lost in September.

Analysts reckon that labor market slack and muted inflation pressures mean Federal Reserve policymakers, who meet on Tuesday and Wednesday, will keep their support for the economy in place for some time. The Fed cut overnight interest rates close to zero in December and have held them there ever since.

Despite the fall in disposable income, Americans saved more money last month. Savings increased to an annual rate of $355.6 billion, lifting the saving rate to 3.3 percent from 2.8 percent in August.

The spending report also showed a key inflation gauge monitored closely by the Fed, the price index for personal spending excluding food and energy, rose only 1.3 percent over the last 12 months. Fed officials would prefer to see it closer to 2 percent.

Separately, the Labor Department said wages rose a meager 0.4 percent in the third quarter, pushing the gain over the past year down to just 1.5 percent, the smallest on records dating back to 1982.

(Additional reporting by Lisa Lambert in Washington; Steven C Johnson and Walden Siew in New York; Editing by Neil Stempleman)

Michigan Inflation Unemployment