U.S. consumer spending slipped in August but falling gasoline prices elevated shoppers' moods by September and Midwest factory activity picked up as well, according to reports on Friday that suggested the economy was still motoring along.

Meanwhile, consumer prices outside food and energy edged up just 0.2 percent in August, although year-on-year price gains hit an 11-year high, offering a mixed reading on inflation.

U.S. Treasury debt prices fell on views the industrial sector was in better shape than earlier thought, while the dollar rose and stocks were down slightly.

Generally the picture painted by the Chicago manufacturing and University of Michigan consumer sentiment data is that the economy continues to expand - that's a negative for a bond market that is primed for the economy to slow abruptly, said Chris Rupkey, vice president and senior financial economist at Bank of Tokyo/Mitsubishi in New York.

The University of Michigan's closely watched consumer sentiment index rose to 85.4 in September, up from 82.0 in August and the highest since April.

Analysts tied the improvement to the demise of $3 per gallon gasoline that dogged Americans for much of the summer, as well as well-publicized trek toward record highs in key U.S. stock indices.

I am not surprised that the consumer confidence is a little bit better than expected because people are seeing pump prices of gasoline come down, said James Glassman, chief U.S. economist at JP Morgan Chase in New York. It doesn't tell you much about their spending power.

Indeed, on a day crammed with economic data, the U.S. Commerce Department said that real consumer spending in August fell for the first time since September 2005.

A key indicator of business conditions in the U.S. Midwest, the National Association of Purchasing Managers-Chicago index jumped unexpectedly to 62.1 in September from 57.1, beating out even the most optimistic forecasts. Economists, on net, had expected a small decline.

The Chicago PMI is very volatile, Glassman noted.

A reading above 50 on the index shows expansion in the Midwest economy, and one above 60 suggests much stronger growth than a number of other regional surveys recently.

Still, the purchasing managers' index from the neighboring Milwaukee, Wisconsin, area slumped to 56 points from 62 in August as new orders and production fell.

Common to both regions was a decline in the employment indices, suggesting companies are becoming less willing to hire new staff. Measures of prices paid were also down on the month - as expected, given the trend in energy prices.

It leaves forecasters with something of a quandary over the Institute for Supply Management on Monday. Our inclination is to look for nothing more than a modest dip, said Ian Shepherdson, chief U.S. economist at High Frequency Economics in Valhalla, New York.

The ISM's national factory survey is seen as a key indicator for the health of the manufacturing sector that cuts through the noise of numerous regional reports. It is forecast to decline slightly.

INFLATION STILL A FACTOR

The Commerce Department said core U.S. consumer prices rose 0.2 percent in August, as expected. But the year-on-year rate of nonfood, nonenergy inflation rose to 2.5 percent, the highest since April 1995, and well above the 1 percent to 2 percent seen as a comfort zone by some Federal Reserve officials.

It reinforces the Fed's view that the risk is still tilted toward higher inflation, said Scott Brown, chief economist at Raymond James & Associates in St. Petersburg, Florida.

Short-term rate futures still suggest the Fed will hold interest rates steady through year-end as it balances uncertain growth prospects with higher-than-desired inflation.

Anecdotally, Americans sense that inflation is coming down, if slowly. The Michigan survey's forecast of five-year inflation fell to 3.0 percent in September from August's 3.2 percent.

It looks like the worst of the inflation news may be behind us, but there is always the prospect of surprises, William Poole, President of the Federal Reserve Bank of St. Louis, told reporters after delivering a speech in Murfreesboro, Tennessee.

Meanwhile, inflation-adjusted spending in August fell surprisingly by 0.1 percent, the first decline since a 0.3 percent drop in September 2005.

It seems that consumer spending is winding down, but will probably do a little better between now and the end of the year due to the drop in gasoline prices, said Mark Vitner, senior economist at Wachovia Securities in Charlotte, North Carolina.

Wage and salary income edged up 0.1 percent. The personal saving rate improved to a negative 0.5 percent, but it was nevertheless the 17th consecutive negative reading in that category.

(Additional reporting by Mark Felsenthal in Washington and Burton Frierson and Zubin Jelveh in New York)

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