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Consumers are spending more even though they have less cash in their pockets as the stimulus wave passes, according to a government report.

By Catherine Clifford, CNNMoney.com staff writer
Last Updated: August 29, 2008: 9:41 AM EDT

NEW YORK (CNNMoney.com) -- Personal income fell in July by the biggest drop in 3 years after surging the prior two months because of $90 billion in economic stimulus payments.

The Commerce Department said Friday that individual income decreased by 0.7% in July after a 0.1% jump in June and a 1.8% increase in May. Economists polled by Briefing.com were expecting income to fall by 0.2% in July.

The sharp decline in personal income was the largest drop off since August of 2005, when personal income plunged by 2.3%, according to the Bureau of Economic Analysis.

Personal spending in July increased by 0.2%, which was in line with economists' expectations. In June, consumer spending had increased by 0.6%.

The uptick in consumer spending was primarily driven by higher prices, however. Individual spending, when adjusted for inflation, actually fell by 0.4% in July, after dipping by 0.1% in inflation-adjusted dollars in June, according to the report.

Another measure in the report that tracks prices that consumers pay on goods and services, excluding food and energy, rose by 0.3% in July over the previous month.

In addition, the core personal consumption expenditures index - a year-over-year inflation gauge that also excluded food and energy - rose by 2.4% in July from the same month a year ago. Core PCE was 2.3% in June. The Federal Reserve is widely believed to prefer that the core PCE stay in a range of 1% to 2%.

Personal income fell in July, but disposable personal income sank even further. Disposable personal income - which is what consumers have after they pay taxes - fell by 1.1% in July, after a 1.9% tumble in June. In May, however, disposable income jumped by 5.7%, largely due to the initial wave of stimulus checks.

The stimulus program provided consumers with cash to spend, and in general, Americans spent it, boosting the nation's economy. On Thursday, second-quarter gross domestic product was revised up to 3.3% annual growth, after being initially reported at 1.9%, according to the Commerce Department.