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Yikes! Economy shrank in fourth quarter for the first time since ’09

The U.S. economy contracted slightly in the final months of 2012, as defense spending plummeted and businesses depleted their inventories, in a surprising development that could give hints of the economic challenges to come.

Wednesday afternoon, after completing their first policy meeting of the year, Federal Reserve leaders signaled that they saw the decline not as indicative of some bigger downturn in the economy. Evidence since their December meeting "suggests that growth in economic activity paused in recent months, in large part because of weather-related disruptions and other transitory factors," the Federal Open Market Committee, the central bank's policymaking group, said in a statement. The officials left their current policies in place, maintaining near-zero interest rates and a program of buying $85 billion in securities each month.

Gross domestic product fell at a 0.1 percent annual rate in the fourth quarter, the Commerce Department said Wednesday, far below the 1.1 percent gain that analysts had forecast. The number will be revised extensively in the months ahead as more complete data becomes available, but if the number stays in negative territory, it would be the first contraction for the U.S. economy since the second quarter of 2009.

The good news is that the biggest factors in the decline aren't expected to repeat themselves. Underlying growth in consumer and businesses spending was reasonably strong: Personal consumption expenditures rose at a 2.2 percent annual rate, while business spending on equipment and software rose at a gangbuster 12.4 percent rate. Housing continued a bull run, with residential investment rising at a 15.4 percent annual rate for its seventh straight quarter of expansion. (Click here for a full rundown of how much different sectors added to--or subtracted from--GDP)

It was, said J.P. Morgan Chase economist Michael Feroli in a report, "a disconcerting headline number which masked better underlying performance of the economy."

Indeed, the contraction was caused by two overwhelming factors, and they were doozies.

First, federal defense spending fell at an astounding 22.2 percent annual rate in the quarter, which subtracted 1.28 percentage points from GDP growth. That was in part a reversal from the unusual 12.9 percent gain in the third quarter. But when the two quarters are averaged together, the defense sector was a drag on the economy in the second half of 2012 -- and that's before a "sequester" of automatic defense cuts goes into effect this year if Congress doesn't act to avert it.

A drop in business inventories was the second major drag on growth. Firms drew down their inventories by more than $40 billion, which subtracted 1.25 percentage points from GDP growth. With companies focusing on selling goods already sitting on their store shelves and in their warehouses, production in the nation's farms and factories was not as high as one might expect given consumer and business spending.

But businesses can't simply run down their inventories forever, and that bodes well for future growth. Final sales, which add inventories back in, rose at a 1.15 percent rate.

A third and smaller factor in the contraction was a sharp decline in exports amid a slower world economy. Overall, trade subtracted 0.25 percentage points from the growth rate.

Overall, it was a bad quarter for the U.S. economy, but not nearly as bad as the overall negative number would suggest.

"The economy ended 2012 on a very sluggish pace, even though onetime factors put the number below the trend," said Kathy Bostjancic, an economist at the Conference Board. Markets were little affected by the news, with the Standard & Poor's 500 index down 0.1 percent at 11:50 a.m.

GDP is the broadest measure of economic output, aiming to capture the value of goods and services produced within U.S. borders during a given time. The data over the last three years show an economy stuck in a pattern of steady growth that's not strong enough to significantly push down unemployment nor weak enough to sink the nation into a new recession.

Still, there are reasons for concern in 2013: While consumer spending held up in the final months of 2012, that was before the payroll tax break expired in January, siphoning income from workers' paychecks. And if negotiations over the sequester force steep cuts in defense and other government spending in the months ahead, GDP could suffer a steeper decline. In that sense, the portrait painted by the new numbers, of a private sector holding up but counterbalanced by a contracting public sector, may be an indicator of the new normal.