Consumer spending rose modestly in January, getting the year off to a soft start, as households took advantage of tax cuts to rebuild their savings.

Other data on Monday painted a bullish picture of the manufacturing sector, with a gauge of factory activity in the country's Midwest hitting a 22-1/2 year high this month, which should help the economy weather rising oil prices and maintain its steady growth momentum.

The Commerce Department said on Monday spending edged up 0.2 percent, the smallest increase in seven straight months of gains, after an upwardly revised 0.5 percent rise in December.

While bad weather was partly blamed for the below-forecast rise in spending, it also suggested that spending would slow down after growing briskly in the final three months of 2010 as consumers deal with rising food and gasoline costs.

It appears consumers are pulling back both because a lot of spending was concentrated in the fourth quarter and also because rising food and energy prices are crimping purchasing power, said Julia Coronado, an economist at BNP Paribas in New York.

Economists had expected spending, which accounts for 70 percent of U.S. economic activity, to rise 0.4 percent. Real spending fell 0.1 percent, the first decline in a year, after rising 0.3 percent in December.

Spending in the fourth quarter grew at a 4.1 percent annual rate, the fastest in more than four years. That helped to lift economic growth to an annualized 2.8 percent rate from 2.6 percent in the third quarter.

A separate report showed the Institute for Supply Management-Chicago's index of business activity in the Midwest rose to 71.2 in February -- the highest since July 1988 -- from 68.8 in January.

A reading above 50 indicates expansion in the regional economy. Economists had expected the index to dip to 67.7 and the rise this month reflected increases in new orders, backlogs and deliveries.

TAX DEAL BOOSTS INCOMES

U.S. stocks traded higher, while government bond prices were little changed. The U.S. dollar fell to a 3-1/2 month low against a basket of currencies.

Incomes rose 1.0 percent last month, the largest increase since May 2009, lifted by the implementation of a payroll tax holiday, which was part of a $858 billion tax package enacted last year. The boost to incomes is likely temporary.

The increase in January outpaced economists' expectations for a 0.4 percent gain and followed a similar rise in December. Savings jumped to $677.1 billion, the highest level since August, from $620.9 billion in December.

The report also showed the Federal Reserve's preferred measure of consumer inflation -- the personal consumption expenditures price index, excluding food and energy - edged up 0.1 percent last month, after being unchanged in December.

Fed officials prefer the core personal consumption expenditures price index as a gauge of consumer inflation because it takes into account changes in spending habits by households.

New York Fed President William Dudley on Monday cautioned against overreacting to developments in the Middle East and North Africa, which have pushed oil prices and stoked inflation fears.

It is premature to make strong judgments today, Dudley said. If oil prices rose on a sustained basis, he said, and fed through into broader prices, that would be something that the Fed takes seriously, he said.

Fed officials have maintained their view that core inflation rates remain too low, even as high food and energy prices have put global central banks on alert for inflation.

Fed Chairman Ben Bernanke testifies to Congress on Tuesday and Wednesday, and analysts do not expect him to depart much from the central bank's view of low inflation.

In the 12 months through January, the core PCE index rose 0.8 percent after rising by the same margin in December.

A third report showed the recovery continues to elude the housing sector. The National Association of Realtors Pending Home Sales Index, based on contracts signed in January, declined 2.8 percent to 88.9.

Pending home sales lead existing home sales by a month or two.

(Reporting by Lucia Mutikani; Editing by Andrea Ricci)

Ben Bernanke BNP Paribas Manufacturing