Economy much weaker than expected

The economy grew at a much weaker-than-expected pace in the last three months of 2007.

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NEW YORK (CNNMoney.com) -- Economic growth nearly ground to a halt in the last three months of 2007, according to a government report released Wednesday that showed the sharpest decline in growth since 2003.

The report raised fears of a recession and increased hopes that the Federal Reserve will make another significant interest rate cut today. But it included some worrisome inflation readings could end up tying the Fed's hands.

Gross domestic product, the broadest measure of the nation's economic activity, grew at an annual rate of 0.6%, adjusted for inflation, in the fourth quarter, according to the Commerce Department.

That's down from a final reading of 4.9% growth for the third quarter. Economists surveyed by Briefing.com had forecast GDP growth would slow to 1.2%.

The anemic growth in the fourth quarter matched the slowest expansion in the economy in the past five years. The report comes amid rising concerns that the U.S. economy is falling into a recession, with some economists arguing the downturn started in the final month of 2007.

Commerce Secretary Carlos Gutierrez told CNNMoney.com he still expects the economy to avoid falling into a recession, but the report is further proof that Congress must act quickly on an estimated $150 billion financial stimulus package passed by the House Tuesday.

"We're not happy with 0.6% GDP growth," he conceded. "This is exactly why we need to get the stimulus package out as soon as possible and get checks into consumers' hands."

The weak economic reading also comes as the Fed concludes a two-day meeting to consider whether or not to cut interest rates once again in order to spur the economy and ward off a recession. The central bank has already lowered rates by 1.75 percentage points since September, including an emergency 0.75 percentage point cut, also known as a 75 basis point cut, a week ago.

Investors are betting the Fed will cut rates at least another quarter-percentage point. And according federal funds futures on the Chicago Board of Trade, investors were pricing in 80% likelihood of a half-point cut as of mid-morning trading Wednesday.

"Today's GDP figures give the Fed the green light to cut the federal funds rate," said Mark Vitner, senior economist at Wachovia, which is one of the firms looking for a half-point rate cut.

Inflation worries rise. But while economic weakness may allow the Fed to aggressively cut rates, the inflation readings in the report could be a concern for the central bank. The so-called price deflator, which measures prices overall, rose at a 2.6% annual rate, up from only a 1% rise in the third quarter but in line with forecasts.

Perhaps of greater concern is that the so-called core PCE deflator - a more closely watched inflation reading that measures prices that individuals pay excluding volatile food and energy prices - rose 2.7%, higher than the 2.5% economists were predicting and up from a 2% reading in the third quarter.

Many economists believe the Fed would be more comfortable with this measure of inflation rising between 1% and 2%.

But Gus Faucher, director of macroeconomics for Moody's Economy.com, said the GDP report showed enough weakness across broad swaths of the economy that a recession now appears more likely than it did before the report. The Fed may have little choice but to go ahead and cut rates aggressively, he said.

"I think they're committed at this point," said Faucher. "The core PCE is certainly higher than what the Fed would like to see. But given the overall weakness in the report, it's hard to see where inflationary pressures are going to be coming from in the future. Given what the Fed said last week, I think we still get a half-point cut."

Widespread weakness. The slowdown in the housing sector shaved almost 1.2 percentage points off of the growth rate, as spending on residential construction fell at nearly a 24% annual rate.

Changes in non-farm inventories also shaved nearly 1.2 percentage points off overall growth, suggesting that businesses could be pulling back in anticipation of a slowdown. But Gutierrez said he believes that's a sign that businesses will pick up production in the first quarter in order to replenish those inventories.

The output from U.S. auto plants cut 0.9 percentage points off growth, marking the biggest drag from that sector in two years.

Personal consumption, a proxy for spending by individuals on everyday needs, added nearly 1.4 percentage points to growth. But that was a relatively weak reading for the fourth quarter, which includes the holiday shopping period.

The only time fourth-quarter personal consumption has grown at a slower rate than this in the past five years was in 2005, when the economy took a hit from Hurricane Katrina.