U.S. Economy Cools As Consumers Pull Back

By Nell Henderson
Washington Post Staff Writer
Saturday, July 29, 2006

The U.S. economy slowed sharply in the three months ended in June, expanding at less than half its pace earlier this year, as consumers and businesses hunkered down in response to climbing inflation and interest rates.

Consumers spent more on gasoline while pulling back on purchases of houses, automobiles and many other items. Businesses slashed their spending on housing construction and on equipment and software, while hiring more cautiously at a time of uncertainty over how much the economy will cool.

All totaled, the nation's gross domestic product, which measures the value of all goods and services produced in the United States, rose at a below-average 2.5 percent annual rate in the second quarter, a sharp drop from the rapid 5.6 percent pace of the first quarter, the Commerce Department reported yesterday.

The economy is probably not sliding into recession, according to private and government forecasts, but it has started the transition from a heady two years of fast growth stimulated by very low interest rates to a more modest, but more normal, pace of expansion, analysts said yesterday.

"It adds up to an economy heading into a fairly significant slowdown . . . with consumers facing a lot of headwinds," said Nariman Behravesh, chief economist for Global Insight Inc., a financial analysis firm.

Consumer prices shot up at a heated 4.1 percent annual pace in the second quarter, according to Commerce's inflation measure. That was more than double the rate in the previous quarter, and it matched the rate of the third quarter of last year, when energy prices soared after hurricanes Katrina and Rita.

Workers' wages, salaries and benefits -- which economists call "labor compensation" -- are rising, too, but they are not keeping up with inflation. Compensation rose 0.9 percent in the last quarter, up from a 0.6 percent increase in the previous quarter, according to the Labor Department's employment cost index, which was also released yesterday. For the 12 months ended in June, compensation rose 3 percent.

Despite higher prices and slower growth, "there are no clear signs that the economy is close to a recession," said Eugenio J. Alemán, senior economist for Wells Fargo Economics, noting low unemployment and evidence that "the real estate market is slowing down but not collapsing."

Stocks and bonds rallied yesterday on hopes that slower economic growth will encourage Federal Reserve policymakers to stop raising interest rates soon, after two years of steady hikes aimed at keeping a lid on prices.

After the GDP report was released yesterday, traders in futures contracts bet that Fed policymakers will leave their benchmark short-term interest rate unchanged at 5.25 percent at their next meeting, Aug. 8, which would mark the first meeting since June 2004 without a hike. On Thursday, the markets saw the outcome of the next meeting as roughly a tossup.

Fed Chairman Ben S. Bernanke indicated to Congress last week that he and his colleagues are counting on a cooler economy to weaken price pressures over the next 18 months -- a sign that they don't plan to raise interest rates high enough to cause a sharper slowdown this year. Their report to Congress showed that they expect the economy to grow at about a 2.5 percent annual rate for the rest of the year and then rebound to a pace around 3.2 percent next year.

But Bernanke also warned earlier this year that even if the central bank pauses in its series of rate increases, that would not necessarily mean it would be done tightening credit. And several analysts said yesterday that they still expect the Fed to lift the benchmark rate to at least 5.5 percent before year-end to combat rising inflation.

Much of the inflation in the second quarter was due to rising energy prices, as oil shot above $70 a barrel and gasoline averaged close to $3 a gallon. And oil and gasoline prices have moved higher since June, suggesting that price pressures remain strong.

More troubling to many economists were signs that businesses are passing their energy costs on to consumers and are finding it easier to raise prices generally. "Core inflation," which excludes volatile food and energy items, rose at a 2.9 percent annual rate in the second quarter, according to the Commerce Department's measure, which is favored by Fed policymakers. That was up sharply from the 2.1 percent rate of the first quarter and well above Bernanke's preferred range of 1 to 2 percent.

The jump in core inflation "is probably the worst news" in the GDP report, because it suggests that the problem is broader than energy costs, Behravesh said. When the rise in labor compensation is added, he said, "the worry is that inflation is beginning to get built into the system."

The economy cooled in the April-to-June period primarily because consumer spending rose more slowly, at an annualized 2.5 percent rate, down from a 4.8 percent pace in the first quarter, Commerce said.

Commerce also revised its economic figures for 2002 through 2005 to show slightly slower growth and higher inflation than previously reported. The economy, for example, grew 3.2 percent last year, revised down from an earlier estimate of 3.5 percent.

Similarly, for 2002 through 2005, GDP grew at an average annual rate of 3.2 percent, after adjusting for inflation -- not the 3.5 percent previously reported, Commerce said.

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