* Pace of U.S. factory activity contraction slows
* Consumer spending falls in December
* Construction spending down 1.4 percent in December
(Adds Fed loan survey, updates market prices)
By Lucia Mutikani
WASHINGTON, Feb 2 (Reuters) - U.S. factory activity contracted at a slower pace in January as credit markets improved, data showed on Monday, but the general picture remained one of an economy sliding deeper into recession.
While news that the Institute for Supply Management's index of national factory activity rose to 35.6 from a nearly three-decade low of 32.9 in December gave some faint hope for the embattled economy, other reports painted a bleak image.
The improvement in the ISM index was its first since June, but it stayed well below the break-even figure of 50, showing the sector continues to contract sharply.
"We're still in a hole that we have a good ways to dig out of and it doesn't look like we got started on that digging process in January," said David Resler, chief economist at Nomura Securities International in New York.
The weak data and uncertainty over the Obama administration's package of spending and tax-cut measures that could cost close to $900 billion weighed on the Dow Jones industrial average. It closed down 64.11 points at 7,936.75 <.DJI>.
Government bond prices rallied, while the dollar stumbled against the yen. A separate survey also showed that the rapid decline in global manufacturing activity was less severe in January, but the sector as a whole remained mired in a deep downturn. [ID:nL2536932]
Analysts attributed the small recovery in U.S. manufacturing to a slight improvement in credit markets, following aggressive measures by the Federal Reserve, that included cutting its overnight lending rate to a range of zero to 0.25 percent, buying securities and making loans.
A reading on employment held at 29.9 in January, indicating job losses in the sector continued unabated, the report showed. But slightly encouraging was that a subindex measuring new orders rose to 33.2 in January from 23.1 in December.
The year-long recession, triggered by the collapse of the U.S. housing market, has been marked by soaring unemployment as companies respond to a slump in demand.
"The January (ISM) readings are still consistent with an economy in deep recession. This report is 'less bad' but clearly not 'good'," said Michael Darda, chief economist at MKM Partners in Greenwich, Connecticut.
"Unfortunately, none of the indicators we follow, credit markets included, have turned enough to suggest that an upturn is imminent. Instead, the best we can hope for at this point is for the pace of economic decline to slacken as 2009 unfolds."
According to a closely watched quarterly survey of lending conditions by the Fed, a majority of domestic and foreign banks tightened lending standards to businesses and households over the last three months. [ID:nN02452311]
Separate data from the Commerce Department showed consumer spending, which accounts for two-third of U.S. economy activity, was depressed in December. Households facing diminishing job security opted to build their savings.
Consumer spending fell by 1 percent in December, a sixth straight monthly decline, after dropping by 0.8 percent in November. With companies cutting down on hours and reducing payrolls, incomes fell by 0.2 percent after November's 0.4 percent decline.
On an inflation-adjusted basis, consumer spending fell 0.5 percent during the month.
CONFIDENCE SHATTERED
"With incomes falling ... and confidence shattered, we have to expect spending to keep falling for some months yet," said Ian Shepherdson, chief U.S. economist at High Frequency Economics in Valhalla, New York.
For the whole of 2008, spending rose 3.6 percent, the smallest increase since 1961. Incomes increased 3.7 percent, the smallest advance since 2003.
The spending data was incorporated in a report on Friday that showed the economy shrank at its fastest pace in nearly 27 years in the fourth quarter. Many economists expect an even deeper contraction in the first three months of this year.
With the economy's collapse, inflation pressures have eased considerably. A price index tied to consumer spending rose just 0.6 percent on a year-over-year basis in December, down from 1.4 percent in the 12 months through November.
Excluding food and energy, the inflation rate slowed to 1.7 percent from 1.9 percent in November. Analysts said the trend, if sustained, could lead to deflation, a broad decline in prices that could further damage the economy.
So far, the core price index is in a range officials at the Fed would welcome, but the risk of a sharp slowing has caught their attention.
"You are seeing a rapid slowdown in the core (price index) which raises the possibility of prices falling below the Fed's comfort zone," said Pierre Ellis, senior global economist at Decision Economics in New York.
"It will not happen soon and it may be brief. But a sharp deceleration will make anybody nervous."
In a sign the recession was forcing households to change their behavior, the personal saving rate surged in December to 3.6 percent of disposable income, the highest since May, from 2.8 percent in November, the Commerce Department said.
In a separate report, it said spending on construction projects dropped 1.4 percent last month, the biggest decline since July. For 2008, construction spending plunged by a record 5.1 percent. (Additional reporting by Corbett Daly in Washington, John Parry and Ellen Freilich in New York; Editing by Chizu Nomiyama)