Economic growth slowest in four years

NEW YORK (CNNMoney.com) -- Economic growth sank to the slowest pace in four years in the first quarter, the government reported Friday, as the weak housing market, coupled with higher prices, took a big bite out of the world's largest economy.

While a slowdown had been expected, the reading came in far weaker than most economists' forecasts. Sluggish spending by businesses was another culprit.

"We are seeing housing affecting consumers," said Michael Strauss, chief economic for Commonfund, an asset manager serving not-for-profit clients. "We're seeing a major drag on discretionary spending."

The Commerce Department said gross domestic product grew at a 1.3 percent annual rate in the quarter, down from the 2.5 percent rate in the fourth quarter. Economists surveyed by Briefing.com had forecast GDP, the broadest measure of the economy, would slow to growth of 1.8 percent in the quarter.

The growth was the weakest since the 1.2 percent rate in the first quarter of 2003, and was even far weaker than the 1.8 percent growth seen in the fourth quarter of 2005 after the damage done to the economy by Hurricane Katrina.

The report was the department's initial reading on GDP and will be revised twice in coming months.

The slumping housing market subtracted almost a percentage point from growth. While that was somewhat less of a drag on the economy than the two previous quarters, some economists had thought that the battered real estate market would no longer be such a negative by this point.

"We didn't think housing was going to be as much of a drag as it was," said Jeoff Hall, chief U.S. economist for Thomson Financial.

Spending by consumers grew at a 3.8 percent rate in the quarter, down from the 4.2 percent in the fourth quarter. Strauss said he expects it will slow further in coming quarters.

"Businesses are seeing that the fourth quarter might have been a last hurrah for consumer spending," said Strauss. And he said that's a reason that business spending has been so weak. Spending on equipment and software grew at just a 1.9 percent rate in the quarter.

But Rich Yamarone, director of economic research at Argus Research, said that the 3.8 percent growth was a solid result and shows that the economy is stronger than the overall GDP number would suggest. Spending by consumers accounts for about 70 percent of the nation's economic activity.

"Consumer spending is pretty strong for an economy that is supposedly on the verge of rolling over," he said. "If the economy was that bad you would think that consumers would be spending a lot less."

Yamarone agreed that business spending was disappointing, calling it the fly in the ointment of Friday's report. But he said that with unemployment relatively low, he believes consumers will keep spending even if the housing market continues to struggle.

Commerce Secretary Carlos Gutierrez issued a statement Friday saying he was pleased by the continue growth in GDP, which has shown growth every quarter since the end of 2001.

"While the growth rate is slower than recent quarters, it's important to realize a quarter is only a snapshot of the larger economic picture," said his statement. "Quarterly numbers bounce around, but the bottom line is that our economy remains solid."

But Peter Schiff, president of Euro Pacific Capital, a Darien, Conn. brokerage firm that specializes in overseas investments, said the consumer spending will not be able to continue due to the problems in the housing sector, the continue growth in the trade gap and the nation's negative savings rate, where consumers are consistantly spending more than their after-tax income.

"I think this report is even weaker than the numbers suggest," Schiff said. "Home equity loans have been financing all this consumer spending. We're just at the beginning of the housing slump. Housing is going to collapse, and when it does it's going to take the rest of the economy with it."

The report also showed growing inflation pressures in spite of slower growth, a factor that could limit the Federal Reserve's freedom to cut interest rates in an effort to stave off a slowdown or even a full-blown recession.

The report's measure of prices rose at a 4 percent rate in the quarter - the biggest jump in 16 years - up from only a 1.7 percent rate the prior quarter. Economists, aware of higher food and energy prices, had been forecasting a gain, but only of 3.2 percent.

The GDP number is adjusted for inflation, meaning that higher prices mean less real growth.

The mostly closely watched inflation reading in the report is known as the core PCE deflator, which measures prices paid by consumers for goods other than food and energy. The Fed is believed to prefer to see that rate in the range of 1 to 2 percent. But that came in at 2.2 percent, up from a 1.8 percent rise.

The report had some economists talking about stagflation, the worst-of-all-worlds scenario where the economy shrinks or has little growth while prices rise. But most said that prices are not high enough and growth is not yet slow enough to truly raise stagflation fears.

"I think we need a new term, like slugflation, meaning sluggish growth with some inflation," said Yamarone. "It's not going to lead to recession. I don't see that in the cards."

Still, the report sent stocks lower at the open, although the Dow and Nasdaq soon recovered, helped by the strong earnings and guidance posted by Microsoft (Charts, Fortune 500), a major component of both indexes.