* U.S. consumer spending drops for first time in two years
* Confidence plunges in October; industrial activity weak
* Consumer income in September up at half August's pace (Adds analysis, details; updates market reaction)
By Glenn Somerville
WASHINGTON, Oct 31 (Reuters) - U.S. consumers cut their spending for the first time in two years in September and their mood soured further this month as they braced for tough times with jobs disappearing and the economy in a likely recession.
The Commerce Department said on Friday that spending shrank by 0.3 percent in September while a separate Reuters/University of Michigan survey showed consumer confidence in October took its biggest plunge on record.
The consumer confidence index dropped to 57.6 from 70.3 in September. The survey said consumers offered "the most dismal assessments of their current financial situation ever recorded."
"What the data tell us is that consumers are in retreat caused by wealth losses in both real estate and financial assets, weaker employment conditions and, at least through the first eight months of the year, a heavy toll from high energy costs," said David Resler, chief economist for Nomura Securities in New York.
Despite the bad economic news, share prices rose as investors hunted bargains among beaten-down stocks.
The U.S. economy has already shed 750,000 jobs this year, and economists are warning of a potentially deep and long recession as a widening credit crunch increases pressure on consumers and takes a mounting toll on activity.
"We expect that spending continued to decline in October as credit conditions worsened, equity values fell dramatically and labor market declines intensified," said economist Peter Kretzmer of Bank of America in New York.
Savings rose in September -- to 1.3 cents per dollar of disposable income from eight-tenths of a cent in August -- and may continue to do so as Americans try to dig out from debt.
"Over the next couple of years, we expect that rate to climb to 6 percent or so as consumers finally capitulate and start the long process of consolidating their financial positions," said Paul Ashworth, senior U.S. economist with London-based Capital Economics Ltd.
PATTERN OF WEAKNESS
A pattern of global weakness is beginning to come into stark relief. A German official told Reuters on Friday that Germany's gross domestic product likely contracted by about 0.25 percent in the third quarter. For details, see [ID:nBEB002248]
If so, that will put Germany -- Europe's largest economy -- into a technical recession with back-to-back quarters of shrinking output after a 0.5 percent decline in the second quarter. Official German GDP figures are scheduled for release on Nov. 13.
Other euro-zone economies also are ailing, with France and Italy also experiencing GDP contractions in the second quarter and expected to sink into recession like Germany.
In the United States, reports from two regional surveys of purchasing managers -- one covering the Milwaukee area and the other Chicago -- underlined a continuing deterioration in industrial activity.
Business activity in the Milwaukee region shrank for an eighth straight month in October and it also weakened more than expected in Chicago.
The 0.3 percent drop in consumer spending in September was the was the largest since a matching fall in May 2005 and followed two flat readings in August and July. Factoring in inflation, September's drop was an even-larger 0.4 percent.
The Commerce Department said on Thursday that U.S. gross domestic product contracted at a 0.3 percent annual rate in the third quarter. The GDP report had already incorporated September's income and spending data.
PAY GROWTH RESTRAINED
A separate Labor Department report on Friday showed U.S employment costs rose 0.7 percent in the third quarter, with wages and salaries also up 0.7 percent.
But on a 12-month basis, total compensation, which includes not only pay but also benefits, rose just 2.9 percent. That was the smallest 12-month gain since March 2006 and provided another marker on the strain on consumers, and a hint at a lessening in inflation pressure.
In September alone, the Commerce Department said income from wages and salaries and other sources gained by 0.2 percent, half the 0.4 percent rise posted in August. Incomes had been boosted earlier in the year by government stimulus payments but that had largely disappeared by September.
Inflation moderated slightly last month. The year-over-year rise in the personal consumption expenditures price index eased to 4.2 percent from 4.5 percent in August. Core prices, which exclude food and energy, rose 2.4 percent in September, slowing from 2.5 percent a month earlier. (Additional reporting by Mark Felsenthal in Washington, Ros Krasny in Chicago and Herb Lash in New York; Editing by Xxxx Xxxx)