UPDATE 1- U.S. August consumer spending up, prices tame

(Adds details, market reaction)

WASHINGTON, Sept 28 (Reuters) - U.S. consumers boosted their spending at the strongest rate in four months during August and core consumer prices posted their smallest year-on-year rise in 3-1/2 years, the Commerce Department reported on Friday.

Spending that is the primary fuel for national economic activity increased 0.6 percent last month, well ahead of Wall Street analysts' forecasts for a 0.4 percent gain and up from a 0.4 percent rise in July. Incomes rose 0.3 percent in August, down from a 0.5 percent July rise.

A monthly measure of core consumer prices, which excludes volatile food and energy items, edged up a scant 0.1 percent for a sixth straight month. On a year-over-year basis, core prices were ahead 1.8 percent, which department officials said was the smallest increase since a matching 1.8 percent rise in February 2004.

The mild core consumer prices rise may be reassuring to Federal Reserve policy-makers, who have been closely monitoring the economy for any indication that inflation pressures might be building.

The Fed cut official interest rates by a half percentage point last week, and many analysts think it will have to reduce them further in order to cushion an expected slowdown stemming from U.S. mortgage market problems that threaten to adversely affect the broader economy.

U.S. Treasury prices gained after the inflation data was issued as investors interpreted it to mean that there was nothing to prevent the Fed from continuing to reduce interest rates. The Fed's "comfort range" for acceptable inflation is generally considered to be 1-2 percent, although policy-makers do not specify that is the case.

Stock futures cut losses in response to the latest signs of tame inflation.

The core inflation data "does give the Fed some room to moderate their inflation concern if they wish to do that. We have a good long string of 0.1 percent (monthly increases) now and we are comfortably below 2 percent," said Richard Gilhooly, senior U.S. bond strategist with BNP Paribas Securities Corp. in New York.