The manufacturing sector has been expanding since August, but economists say economic recovery will be modest, especially with the jobless rate at 10 percent, just off a 26-year high.
The Institute for Supply management said its index of national factory activity rose to 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.
Stock indexes rose following release of the index while government bond prices fell.
The index showed the U.S. economy was keeping pace with others showing expanded factory activity. Chinese manufacturing grew at a near record pace in January.
Economists said businesses replenishing inventories, which fell sharply during the recession, drove the sector's gains.
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 U.S. 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 data due Friday to show the economy added 5,000 jobs last month after shedding 97,000 in December.
A separate Commerce Department report showed consumers were cautious with their credit cards in December, when spending rose 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, and in all of 2009, 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 after rising 0.3 percent in November. The rise in income boosted the savings rate to its highest 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 Barack Obama on Monday projected the shortfall would peak at a record of $1.56 trillion in 2010, or 10.6 percent of GDP, 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 since 2003, hurt by a sharp drop in private residential and state and local government construction.
For graphics on US manufacturing and personal consumption, pls see: http://link.reuters.com/zej96h and http://link.reuters.com/sym96h
(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 and Dan Grebler)