U.S. manufacturing expanded in January at its fastest pace since 2004 but consumers increased their spending only slightly in December, worried by job prospects and the state of the economy.

Although the manufacturing sector has been expanding since August, the data released on Monday showed that the economic recovery is likely to be modest, especially with the jobless rate at 10 percent, an almost 26-year high.

The U.S. manufacturing sector is showing clear and consistent signs of growth and expansion. That said, the elephant in the room remains employment, or more precisely, unemployment, said Michael Woolfolk, FX strategist at BNY Mellon in New York.

The Labor Department is to release its monthly report on nonfarm payrolls on Friday, the most closely-watched data on the jobs market.

President Barack Obama on Monday sent a $3.8 trillion budget request to Congress that would narrow the federal deficit by curbing 120 federal programs but also set aside $100 billion to tackle unemployment.

The Institute for Supply management said its index of national factory activity rose to a reading of 58.4 from 54.9 in December, handily beating economists' median forecast of a rise to 55.5.

A reading above 50 indicates growth in the sector. The prices paid component was at its highest since August 2008.

The manufacturing data helped propel a rise in stocks, with all three major indexes rising more than 1 percent, while government bond prices fell as the demand for less risky assets declined.

The data showed the economy was keeping pace with others showing expanded factory activity. Chinese manufacturing grew at a near record pace in January.

Economists said gains were driven by businesses replenishing inventories, which fell sharply during the recession.

It is telling me that the first half of 2010 is going to be supported by the restocking, said Stephen Gallagher, chief U.S. economist at Societe Generale in New York.

We have a 3 percent to 3.5 percent growth range for the first half of 2010 and based on these numbers we might be underestimating the growth.

The economy grew at a 5.7 percent annual pace in the fourth quarter, its fastest clip in six years, driven by a sharp slowdown in the rate at which businesses reduced stocks of unsold goods, the government said on Friday.

But while the ISM employment component hit its highest level in nearly three years, some economists said the month-on-month gain was fairly modest.

All of the employment numbers are showing that the huge losses in jobs are well behind us but we are not gaining in jobs either, said Jay Mueller, senior portfolio manager at Wells Capital Management in Milwaukee.

Norbert Ore, chairman of the ISM's Manufacturing Business Survey Committee, said the employment index is a good indicator of sentiment rather than actual jobs.

He added: I do think manufacturers are willing to hire if they have the need, but I think it's premature to expect a lot of job growth.

Economists polled by Reuters expect the government's nonfarm payrolls report on Friday to show the economy added 5,000 jobs last month after shedding 97,000 jobs in December. That would be only the second month of jobs gains since December 2007.

CAUTIOUS CONSUMERS

A separate Commerce Department report showed consumers kept a tight grip on their wallets in December, with spending up by just 0.2 percent after increasing by an upwardly revised 0.7 percent in November.

It was the third straight monthly gain in spending, which accounts for about two-thirds of the U.S. economy, but it was less than economists had expected. For the 2009 full year, consumer spending fell 0.4 percent, the largest drop since 1938.

December's slight spending increase came even as real disposable income climbed 0.3 percent, following a 0.3 percent rise in November. The rise in income boosted the savings rate to its highest level since June.

Commerce Department data also showed the personal consumption expenditures price index, excluding food and energy, rose 1.5 percent in December from a year earlier. The index, which is a key inflation measure monitored by the U.S. Federal Reserve, rose 1.4 percent in November.

It suggests that the Fed still has some time to keep interest rates low, said Gary Thayer, chief macrostrategist at Wells Fargo Advisors in St. Louis.

Low interest rates and the aggressive fiscal spending undertaken to prevent a recession turning into a depression have caused a massive rise in the U.S. budget deficit.

President Obama on Monday projected the shortfall would peak at a record of $1.56 trillion in 2010, or 10.6 percent of gross domestic product, before easing.

The central bank left benchmark interest rates near zero last week and repeated a pledge to keep them low for an extended period.

Banks stopped tightening lending standards on many types of loans in the fourth quarter of 2009, the Fed said on Monday, although loan demand from households and businesses fell.

Separate Commerce Department data showed construction spending fell 1.2 percent in December to the lowest level since 2003, hurt by a sharp drop in private residential and state and local government construction.

(Reporting by Steven C. Johnson in New York and Lucia Mutikani in Washington; Additional reporting by Ellen Freilich, John Parry and Emily Flitter in New York; Editing by James Dalgleish, Dan Grebler, Leslie Adler)

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