Data also showed both consumer and construction spending rose more than expected in August, but investment in private projects fell to its lowest level in more than 12 years,

Taken together, the data implied economic activity rose modestly in the third quarter after growth slowed to a 1.7 percent annual pace between April and June.

But it hardly painted a picture of a robust economy more than a year removed from recession, and analysts said that was likely to keep markets bracing for the Fed to act.

"More quantitative easing is on the way. The Fed may see the track of growth being too slow. It may be too close for comfort for them in terms of deflation. I don't know whether they will do it (QE) in November or December," said John Canally, an economist at LPL Financial in Boston.

New York Fed President William Dudley on Friday said high unemployment and low inflation were "unacceptable," adding that more action was probably warranted if the economic outlook didn't improve.

The Fed said last month it was ready to pump more money into the economy to shore up growth and avert a harmful downward spiral in prices. It has already driven benchmark interest rates near zero and bought $1.7 trillion of mortgage-backed and Treasury debt to bolster growth. It holds a policy meeting November 2-3.

MANUFACUTRING SLOWS, INFLATION LOW

Though a small slice of the economy, manufacturing has been a bright spot, with the sector having expanded for 14 straight months. But the pace of growth has slowed in recent months; in September, the Institute for Supply Management's index slipped to 54.4 from 56.3 and employment in the sector also fell. New orders also slowed for a fourth straight month.

Separately, the Commerce Department said consumer spending, which accounts for about 70 percent of U.S. economic activity, increased 0.4 percent after rising by the same margin in July.

But the Fed's preferred measure of consumer inflation -- the personal consumption expenditures price index, excluding food and energy -- rose only 0.1 percent for a fourth straight month. In the 12 months through August, the core PCE index increased 1.4 percent for the third consecutive month.

The Fed warned last week that underlying inflation was below levels policymakers viewed as consistent with the U.S. central bank's mandate of full employment and price stability.

The ISM report and other data on Friday "reinforces the point that Dudley said....that the economy doesn't have to deteriorate at all from here for the Fed to ease," said Carey Leahy, economist at Decision Economics.

U.S. stock prices trimmed earlier gains and Treasuries cut losses after the data.

SPENDING EDGES UP BUT SENTIMENT STILL WEAK

Holding back spending are a 9.6 percent unemployment rate and shrinking household wealth as the economy struggles to recover from the worst recession since the Great Depression.

In August, spending was supported by a 0.5 percent rise in personal income, the largest rise since December, the Commerce Department report showed. The rise in incomes was above market expectations for a 0.3 percent increase and followed a 0.2 percent gain in July.

"The income data could be a very early indication that incomes are starting to recovery a little bit, which of course would be a good thing," said Paul Nolte, managing director, Dearborn Partners in Chicago.

Spending adjusted for inflation rose 0.2 percent after a similar gain in July. The fourth straight month of gains offered hope that consumers continued to prop up economic growth in the third quarter.

With spending a touch below the 0.5 percent rise in disposable income, the saving rate edged up to 5.8 percent from 5.7 percent in July. Savings rose to an annual rate of $661.9 billion.

Overall consumer sentiment also improved a bit in September, with the ThomsonReuters/University of Michigan index's final reading rising to 68.2 from 66.6 earlier in the month.

But concern about whether tax cuts for those earning more than $250,000 would be extended depressed confidence among upper-income earners, the survey's director, Richard Curtin, said, driving one-year inflation expectations to their lowest level in a year.

"It is hardly a surprise that potential reductions in after-tax incomes a few months from now will influence people's current spending decisions," he said.

(Editing by Andrew Hay)