Consumer spending dropped in June for the first time in nearly two years and incomes barely rose, signs the economy lacked momentum as the second quarter drew to a close.

The Commerce Department said on Tuesday consumer spending slipped 0.2 percent, the first decline since September 2009, after edging up 0.1 percent in May. Adjusted for inflation, spending was flat after a 0.1 percent decline.

Incomes rose just 0.1 percent.

"It certainly gets us off on a very soft footing for the third quarter and does call into question a bit the notion of a second half pick-up," said Julia Coronado, North America chief economist at BNP Paribas in New York. "We are not seeing it yet going into the third quarter."

The data, which was incorporated in a report on U.S. economic growth on Friday that showed the economy expanded at less than a 1 percent annual rate over the first half of the year, was the latest to underscore the recovery's frail state.

A report on Monday showed manufacturing activity hit a two-year low in July, leading some economists to dial back expectations for growth over the second half of the year.

For the third-quarter, many economists have scaled back growth estimates to around 2.5 percent from 3 percent.

"If the recovery is ever going to gain speed, it will have to come from households deciding they want to spend money again," said Joel Naroff, chief economist at Naroff Economic Advisors in Holland, Pennsylvania.

U.S. stocks fell on the weak spending report, while prices for Treasury debt rallied. The dollar was up modestly against a basket of currencies.

WEIGHING RECESSION RISKS

Consumer spending is being held back by a 9.2 percent unemployment rate and the labor market's health could determine how fast the economy recovers its footing.

Employment grew by just 18,000 positions in June and a report on Friday is expected to show only a further 85,000 were added in July.

Budget cuts in Washington could prove a headwind for the economy, although forecasting firm Macroeconomic Advisers said the impact from the plan the Senate approved on Tuesday would likely trim an average of 0.1 percentage point off GDP growth over the next ten years.

However, if agreement is not reached on a planned second round of reductions, automatic cuts would be imposed that would curb GDP growth in 2013 by 0.8 percentage points, it said.

The dour data in the last few days have spurred talk the economy could tumble into a fresh downturn.

Federal Reserve officials gather next week to appraise the state of the economy, but officials have signaled a reluctance to build on their aggressive monetary policy stimulus.

In an interview with ABC, Treasury Secretary Timothy Geithner said he did not think the economy was facing a very significant recession risk.

"Construction is very weak, housing is very weak, and confidence ... has been damaged," he said. "But if you look at what's happened to exports, if you look at what's happened to investment spending, there's lots of encouraging signs of resilience, too."

SILVER LININGS

Auto sales, which were held back by supply disruptions after the earthquake in Japan in March, also look set to improve from June's lows. General Motors Co. said on Tuesday sales rose 7.6 percent in July from a year ago.

In addition, borrowing by small U.S. businesses jumped in June to the highest level in more than three years.

There was also a silver lining in the weak spending report, with inflation subsiding as gasoline prices declined.

An inflation gauge that the Fed closely monitors fell 0.2 percent, the first drop since June. A core index, which excludes food and energy costs, rose a tame 0.1 percent.

"That's a little relief for consumers and hopefully over time that will lead to a little bit of momentum in consumer spending," said BNP Paribas' Coronado.

(Additional reporting by Ann Saphir in Chicago; Editing by Andrea Ricci)