U.S. manufacturing shrank at a less severe pace last month and consumer spending bounced back in January, data showed on Monday, but the improvement was likely a blip amid a rapidly deteriorating economy.

Evidence that the 14-month economic downturn was deepening came from a report showing spending on construction projects slumped to the lowest level in over four years in January.

With household wealth falling sharply and revenue-squeezed companies aggressively laying off workers, the economic rout is set to worsen in the months ahead, analysts said. The government has stepped in with a $787 billion stimulus package.

Perhaps consumer spending in the first quarter is not going to decline quite as rapidly as people thought, said Nigel Gault, chief U.S. economist at IHS Global Insight in Lexington, Massachusetts. But if you put all the numbers together they show the economy contracting at least as fast in the first quarter as it did in the fourth quarter.

Coming on the same day as a record $61.7 billion quarterly loss at American International Group and a new government bailout for the insurer, the data helped drive the Dow Jones <.DJI> to close below 7,000 for the first time since May 1997. U.S. government bond prices rallied as investors sought safety in low-risk assets.

The Institute for Supply Management's index of national factory activity inched up to 35.8 in February from 35.6 the prior month, but the employment gauge dived to a record low, raising the specter of an ugly nonfarm payrolls report on Friday.

The modest improvement in the overall index contributed to stability in global manufacturing activity in February. U.S. manufacturers said the gain was likely due to the resumption of production at some auto plants after long holiday closures.

Manufacturing is still mired in the worst downturn since the 1973-74 recession, and there is little on the horizon to suggest improvement, said Thomas Duesterberg, president of the Manufacturers Alliance/MAPI in Arlington, Virginia.

A report from the Commerce Department showed consumer spending rose 0.6 percent in January, the largest increase since May, after falling 1 percent in December.

NO CONSUMER REVIVAL

Analysts said the rise did not signal a consumer revival as household wealth and employment were falling at exceptionally fast rates, with consumer confidence near all-time lows.

Prospects for consumption remain gloomy. Consumers will be faced with much weaker income growth over the next few months, as firms continue to cut payrolls to contain costs, said Anna Piretti, an economist at BNP Paribas in New York.

Rapidly rising unemployment is expected to keep consumer confidence close to historic lows. This will cause even more conservative consumer behavior and therefore less spending.

Data last week showed consumer spending, which accounts for more than two-thirds of economic activity, declined at a 4.3 percent rate in the fourth quarter, the biggest drop since the second quarter of 1980.

That helped to push fourth-quarter gross domestic product to a 6.2 percent annual rate of decline.

Incomes advanced 0.4 percent in January, the biggest increase since May, after December's 0.2 percent decrease, the Commerce Department said.

The government attributed the rise in incomes to pay increases for federal civilian and military employees, as well as cost-of-living adjustments to several government transfer payments programs. It said excluding these factors, incomes increased by 0.2 percent in January.

Private wages and salaries fell $25.8 billion in January, compared to a decrease of $27.0 billion the prior month, following smaller-than-usual bonus payments.

In yet another sign that consumers were not ready to loosen their purse strings, savings jumped to an annual rate of $545.5 billion in January, the highest level since monthly records began in 1959, the Commerce Department data showed.

The saving rate surged to 5 percent in January, the highest level since March 1995.

It is good that people save, but it is not good that everybody saves at the same time. That makes the current downturn more severe and long-lasting, said Scott Brown, chief economist, Raymond James & Associates in St. Petersburg, Florida.

In another report that highlighted the severity of the current economic downturn, the Commerce Department said spending on construction projects dropped 3.3 percent to a seasonally adjusted annual rate of $986.2 billion, the lowest rate since June 2004, after tumbling 2.4 percent the prior month.

Private residential spending fell 2.9 percent in January after December's 4.4 percent drop. Compared to the same period last year, spending was down 28 percent. The level of spending, at a $291.5 billion rate, was the lowest in over 10 years.

(Additional reporting by Burton Frierson in New York; Editing by Neil Stempleman and Leslie Adler)

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