The ISM index of national factory activity rose to 52.3 from 49.3 in January, above economists' median forecast for a slight rise to 50.0.
U.S. stocks indexes pared steep losses after the factory data. The Dow Jones Industrial Average at one point was down 200 points before the data, but was down about 40 points at midday. U.S. government debt prices were higher, while the dollar rose against the euro.
Consumer Spending Strong
The data on Thursday showed that consumers, the most important piece of the economic pie, increased their spending in January on the backing of bigger income gains than expected.
"The consumer remains the rock of the economy. Households bought tons more of all types of goods in January," said Joel Naroff, president and chief economist at Naroff Economic Advisors.
Personal income rose 1% in January, the biggest gain in a year, while spending rose 0.5%, the Commerce Department said.
That was well ahead of expectations for a 0.3% advance in personal income and a 0.45 rise in personal consumption expenditures.
However, incomes were boosted by bonuses to Wall Street traders, raises for federal workers and annual cost-of-living increases for government programs. Excluding these special factors, personal income would have rise 0.4%.
The housing sector's weakness continued take its toll on the economy, with construction spending in January down 0.8% on the 10th straight monthly decline in residential building. Home prices though were still rising in the fourth quarter, but at a slower pace. A government report said fourth-quarter home prices were up 1.1% from the third.
The labor market also showed some softening with the four-week moving average of first-time jobless claims at the highest level since October 2005.
The economy is still up against some inflationary pressures.
Core consumer prices, which exclude volatile energy and food costs, rose 0.3% in January, outpacing forecasts for a 0.2% rise after a 0.1% gain in December.
"This is obviously not the direction the Fed wants to see," said Bernard Baumohl, economist and managing director at The Economic Outlook Group in Princeton Junction, New Jersey.
Core prices were up 2.3% from a year earlier after a 2.2% 12-month gain in December. Officials at the Federal Reserve have said they prefer the 12-month rise in core prices to remain between 1% and 2%.
"The core PCE price number was still above the Fed's comfort zone on a year over year basis. This suggests that the Fed is probably going to hold interest rates steady for a while," said Gary Thayer, chief economist at A.G. Edwards & Sons.
Manufacturing Picks Up
The better-than-expected factory data quelled concerns there would be a higher risk of a U.S. recession later this year, as was suggested earlier this week by former Federal Reserve Chairman Alan Greenspan.
"This should really quiet the market, because there were emerging fears that the global equities sell-off would be further amplified by a deepening recession in U.S. manufacturing," said Ashraf Laidi, senior currency analyst at CMC Markets in New York.
Manufacturing production declined at the end of last year and also fell off in January as businesses were managing an overhang of inventories.
"The reported increase in February production activity suggests that the recent weakness was most likely an adjustment period to excessive inventory accumulation and declining demand in a few major markets like housing and motor vehicles, and not a systemic weakening," said Daniel Meckstroth, chief economist at Manufacturers Alliance.
Jobless Claims Rise
Separate reports showed some softening the U.S. labor markets, which have held steady for some time.
The U.S. Labor Department reported that initial jobless claims rose by 7,000 last week, pushing the four-week moving average of new claims to its highest level since the week of Oct. 29, 2005.
Initial jobless claims hit a seasonally adjusted 338,000, defying analysts' predictions for a fall to 325,000.
At the same time, a report by employment consultants Challenger Gray & Christmas said planned layoffs rose 33% to 84,014 in February as weakness in the housing market and auto industry seemed to spread into other sectors.