Factory activity in the U.S. Midwest hit a 22-1/2 year high in January as orders surged and employment prospects brightened, providing a fresh signal that the economy would stay on a solid growth path this year.

Another report on Monday showed consumer spending ended 2010 on a firmer footing, a trend that economists expected to continue as the labor market recovery gains traction.

The upbeat data, which showed inflation largely under wraps, suggested the economy started the year with strong momentum. Stocks rose as investors set aside jitters over the unrest in Egypt and prices for U.S. government debt fell.

The factory sector news is an important positive omen for the broader economy, because increased production will yield significant income generation, which in turn will fuel stronger household consumption, said Joseph LaVorgna, chief U.S. economist at Deutsche Bank Securities in New York.

The Institute for Supply Management-Chicago said its barometer of Midwestern business rose to 68.8 in January, the highest since July 1988, from 66.8 in December.

Economists had expected the index to slip to 65.0. A reading above 50 indicates expansion in the regional economy.

The jump reflected a surge in orders to their highest level in 27 years and the strongest reading in the employment component since May 1984 -- an encouraging outcome for a labor market whose recovery has lagged economic growth.

It suggested data on Tuesday could show a surprise rise in the Institute for Supply Management's index of national factory activity, whose expansion economists expected to have leveled off this month after recent strong gains.

SPENDING UP

Manufacturing has led the economy's recovery from the worst recession since the 1930s, but consumers are stepping up to the plate. They helped push the economy ahead at a 3.2 percent annual rate in the fourth quarter.

A report from the Commerce Department showed spending, which accounts for 70 percent of U.S. economic activity, increased 0.7 percent in December. That was the sixth straight monthly gain and added to November's 0.3 percent rise.

The higher spending outpaced the 0.4 percent gain in incomes, and savings dropped to $614.1 billion, the lowest level since March.

The spending figures were included in the government's fourth-quarter gross domestic product report on Friday, which showed spending grew at a brisk 4.4 percent pace in the final three months of 2010, the fastest in more than four years.

Economists expect spending to remain solid in the first quarter, bolstered by payroll tax reductions that were included in the $858 billion tax package enacted in December. An expected pick-up in the pace of the labor market's recovery and a rise in stock prices are also seen supporting spending.

We will see a lot of consumers dip their toes back in the water and spend a little more freely than they did last year, said David Resler, chief economist at Nomura Securities International in New York.

The firmer spending tone was highlighted by Darden Restaurants Inc, owner of the popular Olive Garden and other restaurant chains. It forecast earnings for the current quarter and full year above Wall Street's view, citing improving sales.

Bank balance sheets are strengthening as well. A survey of senior loan officers by the Federal Reserve found banks growing more upbeat about the quality of their loan portfolios.

Expectations were significantly more upbeat than in past years, the Fed said. Moderate to large net fractions of banks reported that they expected improvements in delinquency and charge-off rates during 2011 in every major loan category.

Even as the economy picks up and commodity prices surge, underlying inflation remains muted, which should help the Federal Reserve complete its $600 billion bond-buying program as intended to foster recovery.

The Fed's preferred measure of consumer inflation -- the personal consumption expenditures price index, excluding food and energy -- was unchanged in December after edging up 0.1 percent in November.

In the 12 months through December, the core PCE index rose 0.7 percent, the smallest increase since records began in 1959, after increasing 0.8 percent in November. Even the headline PCE price index was up only a relatively modest 1.2 percent.

The Fed will be prone to be more accommodative than restrictive, said Michelle Meyer, a senior economist at Bank of America Merrill Lynch in New York.

(Additional reporting Ann Saphir in Chicago and Richard Leong in New York; Editing by Andrea Ricci and Dan Grebler)

Egypt