By Nell Henderson and Howard Schneider
Washington Post Staff Writers
Saturday, April 28, 2007; D01
The U.S. economy slowed sharply while inflation quickened in the first three months of the year, the government reported yesterday, rekindling concerns that the nation might be sliding into a more serious downturn.
Strong consumer spending was largely offset by plunging home construction, falling exports and tepid business investment from January through March, the Commerce Department reported.
Add it up, and the nation's gross domestic product, a broad measure of economic output, rose at a sluggish 1.3 percent annual rate -- a significant loss of momentum from the moderate 2.5 percent annual rate of expansion in the previous quarter, and the brisk 3.3 percent growth recorded for all of 2006.
Many analysts, including those at the Federal Reserve, forecast the economy to perk up enough to grow at a modest pace through the rest of the year without tipping into a recession. But at the same time, they see rising risks that the economy will deteriorate further, perhaps into a prolonged period of high inflation and weak growth.
"It was a quarter that was beset by the worst of both worlds, more inflation and less economic growth," said Stuart G. Hoffman, chief economist at PNC Financial Services, who called the combination "a hint of stagflation-lite."
Janet L. Yellen, president of the Federal Reserve Bank of San Francisco, said in a speech Thursday night that "economic growth has unexpectedly slowed from 'middling' to a crawl," developments that have "significantly increased the risks to the outlook, both for growth and inflation."
Her comments and the economic data strengthened investors' expectations that the Fed will hold short-term interest rates steady at its next policymaking meeting May 9. Many investors are betting the economy will weaken enough that the Fed will cut rates later this year.
The stock market, which rallied earlier in the week on a series of strong corporate profit reports, showed little reaction yesterday to the economic figures. The Dow Jones industrial average has added more than 800 points in the past month, rebounding from a steep sell-off in February to close yesterday at a record 13,120.94, an increase of 15.44 points over Thursday. But the market's enthusiasm could ebb if economic growth remains modest and earnings weaken.
Analysts worry most about the strength of consumer spending, which accounts for 70 percent of the economy and which kept the economy afloat by rising at a robust 3.8 percent annual rate in the first quarter.
Forecasters expect unemployment to edge higher this year from its very low 4.4 percent rate in March. Analysts also note that American households are coping with heavy debt service, softening home values and rising gasoline prices. If consumer spending falters, the economy could stall or even contract, some observers said.
"If energy and food prices continue on their recent upward path, then it is very likely that the economy will be facing a recession before the end of the year," said Dean Baker, co-director of the Center for Economic and Policy Research in Washington.
Others countered that consumer spending was fueled by a strong 4.5 percent annualized increase in after-tax personal income in the first quarter. Recent job losses related to housing and manufacturing have been more than offset by rising employment in health care, education, finance, tourism and other services.
"The consumer has not been spooked by either the meltdown in housing or the recent rise in gasoline prices," said Nariman Behravesh, chief economist at Global Insight. He said consumer spending would probably slow, but not enough to tip the economy into recession.
Housing, however, remains a drag on the economy. Spending on residential construction fell at a 17 percent annualized rate in the January through March period, the sixth consecutive quarterly decline.
Data show the housing slump is continuing, exacerbated by rising foreclosures that have added to the supply of unsold homes and caused lenders to tighten credit for some buyers. Sales of previously owned homes, which account for about 85 percent of the market, plunged in March by the largest amount in nearly two decades.
The Commerce Department also estimated that U.S. exports, which rose strongly and boosted economic growth last year, fell at a 1.2 percent annual rate in the first three months of this year.
Another soft spot was business spending on buildings, equipment and software, which rose at a 2 percent annual rate in the first quarter -- a modest gain, but an improvement after a worrisome 3.1 percent decline in the fourth quarter of 2006.
Meanwhile, consumer prices jumped at a rapid 3.4 percent annual rate in the first quarter, after falling in the last quarter of 2006, following the path of energy costs. After excluding volatile food and energy prices, consumer prices rose by 2.2 percent, compared with a 1.8 percent rise in the previous three-month period.
Crude oil prices surged yesterday to $66.46 a barrel on the New York Mercantile Exchange, the highest level in almost eight months.
The Commerce Department's report provides a first estimate of GDP growth. The figures will be revised in coming months as more data become available.