By MARTIN CRUTSINGER, AP Economics Writer

WASHINGTON - Consumers shrugged off a rash of bad news to spend more than expected in August while a key measure of inflation eased to the slowest pace in 3 1/2 years. Construction activity also rose above expectations.

The Commerce Department reported Friday that consumer spending rose by 0.6 percent in August, the best showing in four months and better than the 0.4 percent increase that had been expected. Incomes rose by 0.3 percent, slightly lower than had been expected.

A closely watched gauge of inflation was up just 1.8 percent in August, compared to the same period a year ago, the smallest increase since a similar rise in February 2004.

In another report, construction spending posted a surprising 0.2 percent gain in August as strength in non-residential construction offset a continued plunge in home building. Analysts had been forecasting that overall construction spending would fall by 0.2 percent.

The Commerce Department said the increase pushed total spending to a seasonally adjusted annual rate of $1.166 trillion and reflected a 2.3 percent rise in spending on office buildings, shopping centers and other non-residential projects, the biggest increase in this category in six months.

Spending on home building fell by 1.5 percent, the 18th straight drop in this area, with more weakness expected in coming months as builders scramble to cut back production in the face of slumping sales and a record number of unsold homes.

While the worst slump in housing in 16 years and the severe credit crunch that developed in August have raised worries, the good news on consumer spending should bolster the view that the economy will be able to escape the current slowdown without going into a recession. Consumer spending accounts for two-thirds of total economic growth.

The Federal Reserve last week cut a key interest rate by one-half point, a bigger drop than had been expected, in an effort to make sure that the housing and credit problems don't push the country into a recession.

Analysts are hoping that rate cut will be just the first in a series of reductions as falling inflation pressures give the central bank the leeway to focus on weakening growth.

The 1.8 percent rise in core inflation over the past 12 months, which excluded energy and food, is within the Fed's comfort zone for core price increases of between 1 percent and 2 percent.

Core inflation had been above the Fed's target range through the spring of this year. It peaked at a 2.5 percent increase in February.

Excluding inflation, consumer spending also rose by 0.6 percent in August, the best inflation-adjusted performance since last October. Much of the strength in spending came from a big jump in auto sales, which were driven higher by incentives dealers offered to clear out showrooms for the new model year.

The 0.3 percent rise in incomes was down from a 0.5 percent increase in July and was the slowest performance since no change in April.

Employment fell by 4,000 payroll jobs in August, the first employment drop in four years. Rising employment is the fuel for further spending, so there is concern that if the labor market weakens, consumer spending could falter in coming months.

The overall economy expanded at a solid 3.8 percent rate in the April-June quarter, but analysts believe growth slowed significantly to around 2.5 percent in the current July-September quarter and will slow even further in the final three months of the year