Growth picks up, inflation tame

NEW YORK (CNNMoney.com) -- Economic growth picked up in the second quarter while inflation remained tame, the government reported Friday - a balance that could give the Federal Reserve the freedom to cut interest rates if problems in the housing and credit markets put a big dent in growth the rest of the year.

Gross domestic product grew at an annual rate of 3.4 percent in the quarter, the Commerce Department reported, up from a revised 0.6 percent rate in the first quarter. Economists surveyed by Briefing.com had forecast a 3.2 percent gain in GDP, the broadest measure of the economy.

The U.S. economy grew at a 3.4 percent annual rate in the second quarter, while inflation remained tame.

Inflation readings in the report were mostly seen as positive. The broadest measure of prices rose at a 2.7 percent rate in the quarter, down sharply from a 4.2 percent growth rate in the first quarter. That was lower than economists' forecasts.

The so-called PCE deflator, which measures prices paid by consumers, rose 4.3 percent, mostly due to record gasoline prices in the quarter. But the more closely watched "core" PCE deflator, which strips out volatile food and energy prices, rose just 1.4 percent, down from a 2.4 percent rise in the first quarter.

It was the smallest rise in that measure, a favorite of Fed policymakers, since 2003. The Fed is generally believed to want to see the core PCE in a 1 to 2 percent range.

Economist John Silvia said that the bounce back in growth after the weak first quarter doesn't change the outlook for a slowdown in the second half of the year. He's still forecasting only 2.6 percent growth in both the third and fourth quarters.

But Silvia said if growth falls more than expected in the face of a worsening housing slowdown or a credit crunch for businesses, the tame inflation reading gives the Fed the ability to cut rates before the end of the year.

"This opens the door for the Fed to be very flexible," said Silvia, chief economist with Wachovia. "I still think they'll accept below par economic growth in the second half of the year and leave rates unchanged and let the credit market settle themselves. But if we see third-quarter growth fall down to the 1 percent range, we'll see a cut."

The slowdown in housing cost the GDP about a half a percentage point in the second quarter, but that was less of a drag than previous four quarters, when housing cost the economy between from three-quarters to 1.3 percentage points.

Reports of problem of mortgage delinquencies spreading from the subprime sector to prime loans given to buyers with top credit, and surprisingly weak new and existing home sale numbers, have all raised concerns this week that housing will be a bigger drag than expected in the second half of this year.

Meanwhile, corporate credit markets have turned south, raising concerns about access to financing for companies and the private equity firms behind the buyout boom that's lifted stocks this year.

There was some weakness in Friday's GDP report. Consumer spending, which accounts for nearly three-quarters of the nation's economy, rose at a weak 1.3 percent rate, down from 3.7 percent in the first quarter. In addition, spending on equipment and software, a measure of business spending, again fell short of expectations with an increase of only 2.3 percent.

But there was strength in exports and spending by the federal government, which helped account for the better-than-expected reading.