U.S. consumers increased spending for a ninth straight month in March as they stretched to cover higher costs for food and gasoline, with inflation posting its biggest year-on-year gain in 10 months.

Despite the rising cost of living, Americans grew a bit more optimistic about the economy this month and even dialed down their expectations for inflation over the medium-to-long term, another report showed on Friday.

Consumers appear to be taking the high costs in stride, but could be put to the test if gasoline prices shoot above $4 a gallon. The national price for regular unleaded gasoline rose 3.5 cents to $3.88 in the week through Monday.

My guess is that we are not going to see further increases in energy prices as we go through the year. Consumers will continue to contribute to the expansion, albeit in a supporting role, said Richard DeKaser, an economist at the Parthenon Group in Boston.

Consumer spending, which drives 70 percent of the economy, rose 0.6 percent last month after advancing 0.9 percent in February, the Commerce Department said. But prices rose a stiff 0.4 percent month-on-month, leaving spending up just 0.2 percent after adjusting for inflation.

While commodity prices have robbed consumers of purchasing power, they entered the second quarter with a slightly upbeat outlook.

The Thomson Reuters/University of Michigan's consumer sentiment index rose to 69.8 from 67.5 in March. The survey's one-year inflation expectation was unchanged at 4.6 percent, but the five-to-10-year inflation outlook slipped to 2.9 percent from 3.2 percent in March.

JOBS TO LIFT SPENDING

Improving confidence and a strengthening labor market should support spending, even if gasoline prices remain elevated, economists say.

We are looking for consumption to continue to grow in the second quarter, we will probably see (spending) growth pretty similar to what we saw in the first quarter, said Daniel Silver, an economist at JPMorgan in New York.

Consumer spending growth slowed to a 2.7 percent annual rate in the first quarter after a 4 percent rise in the final three months of 2010, the government reported on Thursday.

That gain, which took into account the spending data released on Friday, was a factor behind a slowing in overall economic growth to a 1.8 percent pace at the start of this year from the 3.1 percent expansion in the last quarter of 2010.

MANUFACTURING COOLING?

A third report showed factory activity in the country's Midwest slowed this month, although it remained at a strong level and the data did little to shake economists' convictions that growth would pick up in the current quarter.

Economists said tepid demand in the first quarter had left businesses with less of a need to rebuild inventories.

The need for new orders and production to beef up inventories is greatly reduced and as a consequence, we are seeing the factory sector slow down somewhat, said DeKaser.

Manufacturing is coming off a sprint earlier this year and still moving ahead at a healthy clip.

The mixed economic reports had little impact on U.S. financial markets, with strong earnings from Caterpillar Inc, the world's largest heavy-equipment maker, and carmaker Chevron Corp lifting stocks.

Caterpillar CEO Doug Oberhelman said he was positive on the near-term outlook for the U.S. economy, but that budget cuts were needed in Washington to lay a sounder foundation for growth.

Instead of pointing fingers at each other, the (Obama) administration and members of Congress need to work hand in hand to find solutions that will position the U.S. economy for long-term strength, Oberhelman said.

WAGE GROWTH SUBDUED

The spending report showed consumer prices up 1.8 percent from a year ago -- the largest 12-month gain since May.

An index of core prices, which strips out food and energy costs, rose just 0.1 percent from February, keeping its year-on-year gain at 0.9 percent, just a touch above the all-time low of 0.7 percent struck in December.

Fed officials, who watch the core measure closely to gauge underlying price trends, have said they do not expect lofty food and energy costs to ignite a broad inflation.

Incomes increased 0.5 percent last month after a 0.4 percent gain in February, but wages and salaries only advanced 0.3 percent. With the unemployment rate at 8.8 percent in March, subdued wage growth is helping to keep a lid on prices.

A separate report from the Labor Department showed wages grew at a tepid 0.4 percent rate in the first quarter, and were up only 1.6 percent from a year ago.

(Editing by Andrea Ricci)

Inflation