The U.S. economy experienced a deeper-than-expected slowdown in the second quarter, the Commerce Department reported Friday, as higher interest rates and a slumping housing market caused anxious consumers to cut back on spending.
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The nation’s gross domestic product grew at a 2.5 percent annual rate in the latest period, significantly below the 3.0 percent rate many economists had been forecasting.
“U.S. economic growth is beginning to finally slip,” said Douglas Porter, economist at Toronto-based BMO Nesbitt Burns, “undercut by the combination of a crumbling housing sector and weakening consumer spending.”
On Wall Street, stocks surged as investors welcomed the slackening economic pace as evidence that the Federal Reserve’s long campaign of interest-rate hikes is succeeding in reining in the economy’s expansion.
With Fed officials slated to meet in early August to decide between raising rates for an 18th consecutive time or leaving them at the current level, economy-watchers subjected Friday’s GDP data to unusually intense scrutiny.
The “marked slowdown” in second-quarter GDP growth “materially weakens the case for another rate hike in August,” suggested David Resler, chief economist at Nomura Securities International in New York.
Because there’s a lag of several months between the time a rate hike is implemented and the time it actually begins to slow the economy, Wall Street has grown increasingly concerned that the Fed will “overshoot” its target and raise rates too high, damaging the economy.
The latest GDP report “was welcome news to investors fearful that the Fed would go too far,” observed Jack Ablin, chief investment officer at Harris Private Bank.
Indeed, despite an unsettling hint of growing inflation also contained in the GDP data, the latest evidence of a cooling economy helped push the Dow Jones industrial average up 119.27 points, or 1.07 percent, to a Friday close of 11,219.70.
GDP, which measures the value of all goods and services produced in the U.S., is considered the broadest and best measure of the economy. As recent quarters have shown, however, the indicator can be affected by short-term dynamics such as changes in international trade, the timing of major government expenditures, auto-industry developments or even the weather.
In the first quarter of this year, for example, GDP grew at an unsustainably robust 5.6 percent rate, as the economy rebounded from Hurricane Katrina and other factors that held fourth-quarter 2005 growth to an anemic 1.8 percent.
Economists took a much less optimistic view. Few were surprised by the evidence that consumer spending is slowing, particularly for “discretionary” big-ticket goods, like automobiles, where purchases can easily be deferred.
“The financially strapped consumer is expected to show restraint in the rest of 2006,” said Northern Trust economist Asha Bangalore.
Instead, the biggest surprise lay in an unexpected slowdown in capital spending. For the past four years, the economy’s reasonably steady improvement has been primarily fueled by consumers’ willingness to take on debt and spend freely. During the same period U.S. corporations have cautiously nursed their cash and limited their spending on capital improvements.
Now, with consumer spending beginning to flag, corporations were expected to “take the baton” from the household sector, by revving up capital spending, noted Bangalore. Instead, the economist said, they “apparently dropped it.”
Equipment and software spending, which measures corporate spending, fell 1.0 percent in the second quarter, compared to a whopping 15.6 percent jump in the year’s first quarter.
It was the first quarterly decline in so-called capex (capital expenditures) since first-quarter 2003, noted Merrill Lynch economist David Rosenberg. The 1 percent drop “is a key result,” because the Fed has been anticipating that “business spending growth was going to be a catalyst in terms of providing an antidote to the downturn in the housing sector.”
While the GDP growth data showed the economy losing its momentum, the same Commerce Department report showed that an inflation measure the Fed follows closely moved to its highest rate in more than 11 years. Consumer prices excluding food and energy rose at a 2.9 percent rate in the second quarter, up from 2.1 percent in the first quarter–and widely considered to be above the level with which Fed is comfortable.
Friday’s GDP report “increases uncertainty about the economy and the Fed,” said First Trust Advisors economist Brian Wesbury. “Clearly,” he added, “the market expects the Fed to pause [in August], but this is not a done deal and any pause would be short-lived” because inflationary pressures haven’t yet abated.
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