Aug. 1 (Bloomberg) -- U.S. consumer spending showed the smallest gain of the year in June while prices climbed, making it harder for the Federal Reserve to decide whether slower growth or inflation is the biggest threat to the economy.

Consumer spending, which accounts for more than two-thirds of the economy, rose 0.4 percent after a 0.6 percent gain in May, the Commerce Department said today in Washington. The Fed's preferred gauge of inflation increased 2.4 percent from the same month last year, and hasn't been higher since April 1995.

A separate report from the Institute for Supply Management showed that prices paid for raw materials rose last month by the most since October, and manufacturing accelerated. Fed policy makers meet next week to consider raising rates for the 18th consecutive time or decide that two years of increases are enough to contain inflation.

``The policy ballet will toe what we feel will be a continued murky line between upward pressure on core inflation and evidence concerning the slower pace of economic growth,'' said Joshua Shapiro, chief U.S. economist at Maria Fiorini Ramirez Inc. in New York.

Treasury notes and stocks declined after the reports. Economists forecast spending would rise 0.4 percent, the same as previously reported for May, according to the median estimate in a Bloomberg News survey.

The Commerce Department's report showed incomes rose 0.6 percent, matching the median forecast, after a 0.4 percent increase the prior month.

Paulson Upbeat

Treasury Secretary Henry Paulson, in his first speech and interviews since taking office last month, dismissed concerns the U.S. economy is slowing too much.

``I see a lot of things to be positive about right now,'' Paulson said in an interview in New York, citing stronger demand abroad, expanding business investment and a tightening labor market. ``I'm constructive about the U.S. economy.''

The report's price gauge tied to spending patterns and excluding food and energy costs, the Fed's preferred measure, rose 0.2 percent for a third month in June.

In the second quarter, the government's core personal consumption expenditures index rose at an annual rate of 2.9 percent, the fastest since a 3.2 percent pace in the third quarter of 1994, the Commerce Department's July 28 report on gross domestic product showed.

Price Changes

Taking into account changes in prices, spending increased 0.2 percent for a third straight month in June.

Inflation-adjusted spending on durable goods, such as autos, furniture, and other long-lasting items, rose 0.5 percent after falling 0.6 percent. Purchases of non-durable goods increased 0.3 percent after rising 0.2 percent. Spending on services, which account for almost 60 percent of all outlays, edged up 0.1 percent after rising 0.4 percent.

Growth in manufacturing unexpectedly picked up in July as prices rose, the Institute for Supply Management said. The Tempe, Arizona-based group's manufacturing index rose to 54.7, the highest since April, from 53.8 in June. Its index of prices paid for raw materials rose to 78.5 last month from 76.5.

Construction spending in June increased 0.3 percent, the most in three months, as companies built more factories and offices even as homebuilding slowed, the Commerce Department also said today. Non-residential construction rose by the most in six months.

Policy `Vicinity'

Central bankers are anticipating that slower economic growth will restrain inflation in the months ahead. Fed policy makers have raised their benchmark rate on overnight loans between banks 17 times since June 2004, to 5.25 percent. They next meet on Aug. 8, and odds have decreased for an 18th increase.

``It appears to me that the federal funds rate currently lies in a vicinity that is roughly appropriate for the Fed to attain its key objectives over the medium run,'' Federal Reserve Bank of San Francisco President Janet Yellen said at a speech in San Francisco yesterday. ``If we kept automatically raising rates until we saw inflation start to respond, we most likely would have gone too far.''

Odds of Rate Increase

The probability the Fed will lift rates again this year by a quarter percentage point to 5.5 percent was 100 percent before Fed Chairman Ben S. Bernanke's July 19-20 testimony to lawmakers. The odds dropped to about 30 percent on the August contract for fed funds futures after the GDP report on July 28.

Still, Fed Bank of St. Louis President William Poole said yesterday that he's undecided on whether the central bank should raise interest rates at its next meeting.

``We're going to have to apply all of our analytical skills and our judgment to this decision,'' Poole told reporters after a speech in Louisville, Kentucky, describing his stance as ``50- 50.'' ``I'm still totally noncommittal.''

Today's report showed that the savings rate rose to minus 1.5 percent from minus 1.6 percent in May. A negative rate suggests consumers are dipping into savings to maintain spending.

Disposable income, or the money left over after taxes, increased 0.6 percent after rising 0.4 percent the previous month.

The retail price of a gallon of regular-grade gasoline averaged $2.85 in the second quarter, compared with $2.34 the previous three months, according to figures from the Energy Department.

Retail Sales

Sales at U.S. retailers unexpectedly fell in June, the first decline since February, the Commerce Department reported July 14.

``There is an economic impact of gas prices on the household,'' said Michael Jackson, chief executive of Fort Lauderdale, Florida-based AutoNation Inc., the largest U.S. auto dealer, in a July 27 interview. ``You're seeing that, combined with interest rates which is causing the consumer to pause, which is exactly what the Federal Reserve wants.''

Consumer spending grew at an annual rate of 2.5 percent in the second quarter, compared with 4.8 percent in the first quarter, the Commerce Department said last week. That, along with a slowdown in business demand for software and equipment, held second-quarter economic growth to less than half the first- quarter's pace.

The economy will be hard-pressed to accelerate in the second half as economists forecast consumer spending to grow at a 2.8 percent rate this quarter and 2.7 percent in the final three months of the year, according to the median estimate of economists in a Bloomberg survey June 30-July 10.

Income gains will help gird consumers against higher and energy prices and interest rates, economists said. Average hourly earnings in June rose 3.9 percent from June 2005, the most in five years, the Labor Department said July 7.

To contact the reporter on this story: Joe Richter in Washington Jrichter1@bloomberg.net

Last Updated: August 1, 2006 17:29 EDT