msnbc.com staff and news service reports
updated 1/27/2006 6:06:12 PM ET 2006-01-27T23:06:12

The economy grew at a sluggish 1.1 percent rate in the final quarter of last year, the slowest pace in three years, amid belt-tightening by consumers facing spiraling energy costs.

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The sharp slowdown surprised economic forecasters, although even with the poor showing the the economy registered respectable overall growth of 3.5 percent for all of 2005 — a year when business expansion was undermined by devastating Gulf Coast hurricanes.

The 1.1 percent rate marked a considerable loss of momentum from the third quarter’s brisk 4.1 percent pace and the average 3.6 percent rate of the past four quarters. Economists noted that the GDP figure published Friday was preliminary, and the Bureau of Economic Analysis generally has revised the figure upward in previous quarters.

But still, some analysts said the surprising slowdown means the Fed's long series of interest-rate hikes is beginning to bite.

"The overall message that the lagged impact of the Fed's tightenings are beginning to percolate through the system is coming through loud and clear," said David Rosenberg, chief North American economist for Merrill Lynch, a research note.

The weakness reflected consumers a pullback in consumer spending, especially on motor vehicles, a a sharp downturn in government spending on defense, a category that can be volatile.

Despite what many described as a disappointing report, the Federal Reserve is considered nearly certain to raise short-term interest rates by another quarter-percentage point Tuesday at the final policy-setting meeting of Chairman Alan Greenspan's 18-year term.

But the slowdown raised hopes among some investors that the Fed will shift to a "neutral stance" and leave rates unchanged at the first meeting led by incoming Chairman Ben Bernanke March 28.

Partly as a result, stock prices rose sharply Friday, with broad indicators up nearly 1 percent. Investors also were encouraged by generally good corporate earnings and a surprisingly strong report that new-home sales rose 2.9 percent in December and set a fifth straight annual record for 2005.

In the GDP report, economists said the slowdown in the final quarter was more of a temporary setback rather than any harbinger of a sustained period of economic weakness ahead.

“The economy hit a pothole in the fourth quarter. I’m not at all worried about the health of the economy,” said Mark Zandi, chief economist at Moody’s Economy.com. Zandi believes that economy is already doing better in the current January-to-March quarter and predicts economic growth will come in around a 4 percent pace.

Consumers turned cautious at the end of last year as high energy prices and rising borrowing costs took a toll on their budgets.

Consumer spending rose by just 1.1 percent pace in the fourth quarter, the slowest since the second quarter of 2001 when the economy was suffering through a recession.

Most of the weakness came as people sharply cut back on purchases of big-ticket goods, including cars and appliances. Spending on such “durable” goods dropped by a hefty 17.5 percent rate in the final quarter, the sharpest decline since the first quarter of 1987.

Another source of weakness in the fourth quarter was government spending, which had contributed to overall economic growth in prior quarters. In the fourth quarter, government spending declined at a 2.4 percent pace, the largest drop since the first quarter of 2000.

Administration officials rushed to play down the latest GDP number, with Treasury Secretary John Snow and White House economic adviser Al Hubbard hitting the airwaves to insist the expansion was solid, job growth was strong and businesses were healthy.

“By virtue of every index of economic performance, we’re going the right way,” Treasury Secretary John Snow told a Vermont talk radio show.

White House spokesman Scott McClellan emphasized that growth for all of 2005 was a brisk 3.5 percent.

Democrats seized on the GDP report to blast the White House for pushing tax cuts they say have ushered in high deficits while failing to do enough to help poor and middle-class Americans.

Gene Sperling, a former economic aide to President Clinton, accused the Bush economic team of trying over the past few months to “create a selective and exaggerated picture of the economy” to justify the tax cuts.

Carroll Doherty, an analyst with the Pew Research Center, said the irony was that the main concern of the Bush administration up until now had been calling attention to upbeat figures on payroll growth and jobs the public had largely been ignoring.

“The difficulty for Bush is that there is already a good deal of pessimism out there,” Doherty sai

Analysts were skeptical about the drop in federal spending shown in the report and believed that would be reversed, especially given costs related to the war in Iraq and hurricane cleanup and rebuilding.

Businesses, meanwhile, boosted spending on equipment and software in the final quarter of last year at a 3.5 percent rate, the smallest gain since the first quarter of 2003.

Spending on residential projects also rose at a 3.5 percent pace in the fourth quarter. That was down from a 7.3 percent pace in the prior quarter.

An inflation gauge tied to the GDP report showed prices rose at 2.6 rate in the fourth quarter, down from a 3.7 percent pace in the third quarter.

However, when food and energy prices are excluded, “core” inflation — which the Fed watches closely — rose at a 2.2 percent rate in the fourth quarter, a pickup from the 1.4 percent growth rate in the third quarter. That suggests inflation is filtering into a variety of other prices.

To fend off inflation, the Federal Reserve is expected to boost interest rates next Tuesday one-quarter percentage point to 4.50 percent. It will be last meeting for Alan Greenspan, who will retire that day after more than 18 years running the central bank.

Zandi said the core inflation figures contained in Friday’s report reinforces his belief that the Fed will tighten next week and again on March 28.

President Bush, in his State of the Union address Tuesday evening, plans to put the spotlight on some pocketbook issues, including high energy prices, tax cuts and expensive health care costs.

Public concern about the economy is still relatively high, according to polls. Sixty-four percent described economic conditions as fair or poor, while 34 percent said they are excellent or good, according to the Pew Research Center for People & the Press.

The 3.5 percent increase in GDP for all of 2005, was down from a 4.2 percent gain in 2004. Economists predict the economy for all of this year will turn in another good performance with growth topping 3 percent.

The Associated Press, Reuters and MSNBC.com's Martin Wolk contributed to this story.

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