U.S. retail sales picked up last month after a sluggish December, providing a firm foundation for the economy's recovery.

Sales rose 0.4 percent in January after being flat the prior month, the Commerce Department said on Tuesday.

The January reading was weaker than economists had expected because auto dealers took in less cash. Excluding autos, sales rebounded a solid 0.7 percent, the biggest gain in 10 months.

The consumer is spending and there is certainly no sign of a recessionary downturn, but spending patterns reflect a deleveraging consumer weighted by weak growth and a higher cost of living, said Steve Blitz, chief economist at ITG Investment Research in New York.

Core retail sales, which go into the calculation of U.S. gross domestic product, rose 0.7 percent after declining 0.4 percent in December. Core sales strip out autos, gasoline and building materials.

Investors on Wall Street took a dim view of the report and the Standard & Poor's 500 index <.SPX> retreated from a near seven-month high. Prices for U.S. Treasury debt rose and the dollar rose against a basket of currencies <.DXY>.

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Graphic on U.S. retail sales http://link.reuters.com/guc66s

Graphic on U.S. import/export prices http://link.reuters.com/muc66s

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GASOLINE PRICES RISING

While the economy is expected to take a step back in the first half of the year, a firming labour market and solid manufacturing are seen providing a cushion.

While automakers reported the strongest sales in nearly 2-1/2 years in January, activity was supported by discounts and strong fleet sales. The government, which measures retail sales in dollars, counts fleet sales as a business capital expenditure, not retail activity.

Other data on Tuesday showed confidence among small U.S. business owners rose for a fifth straight month in January.

But economists are worried that a recent increase in gasoline prices, which contributed to the gain in retail sales last month, could hurt spending in the months ahead.

The rise in gasoline prices will likely take a toll on spending in coming months unless income growth improves, said Mark Vitner, a senior economist at Wells Fargo Securities in Charlotte, North Carolina.

Still, the retail sales report adds to a recent run of fairly upbeat economic data, which some analysts say reduce the need for the Federal Reserve to ease monetary policy further through a third round of bond purchases.

A Reuters survey of economists published on Tuesday showed a 35 percent chance of more Fed bond purchases. It also found that economists see a 50-50 chance that the U.S. central bank could raise interest rates before the end of 2014. The Fed said last month it expected to keep rates low until then.

But with unemployment still at an uncomfortably high 8.3 percent, the Fed is still debating its next step.

San Francisco Federal Reserve Bank President John Williams said on Monday it was vital to keep the monetary policy throttle wide open.

His counterpart at the Philadelphia Fed, Charles Plosser, took an opposing view, decrying the accelerationist approach to monetary policy.

I'm not anxious to step on the brake, but I'm not anxious to cut a hole in the floorboard so I can go faster either, he told reporters.

The rise in spending at gasoline stations last month was the biggest since March of last year.

The government revised downward its estimates of retail sales for both November and December.

(Writing by Lucia Mutikani and Jason Lange; Editing by James Dalgleish)