Growth surprises but consumers stressed

WASHINGTON (Reuters) - A buildup in inventories kept the U.S. economy afloat in the first quarter despite the weakest consumer spending since 2001 and reduced business investment, a government report on Wednesday showed.

Gross domestic product grew at a 0.6 percent annual rate in the first quarter, the Commerce Department said. That matched the fourth quarter's advance and topped forecasts for 0.2 percent growth, but did not end a debate on whether the country was sliding into recession.

The Federal Reserve weighed in later with another small cut in official interest rates to counter what policy-makers characterized as weak economic activity.

Some economists said the GDP report suggested the economy was on a bit firmer ground than had been thought, but others braced for worse times ahead as businesses ratchet back production further to try to sell off inventories.

"There are some very troubling signs in this report," said economist Paul Ashworth of Capital Economics Ltd in London. "The GDP figure is being flattered by the strength of demand abroad and an involuntary inventory accumulation."

Stock prices were higher in mid-afternoon in volatile trading. Stocks had a positive tone from early trading, buoyed by hopes that employment will hold up. ADP Employer Services said it found private-sector companies added 10,000 jobs in April, a sharp contrast to forecasts that they would cut jobs.

The government is set to issue its report on April employment this Friday and forecasts are that 80,000 more jobs will be cut. Jobs were lost in each of the first three months this year.

HOUSING STILL WEIGHS

The economy is burdened by a crisis-stricken housing sector that has dimmed consumer optimism and fueled worry that spending will shrivel in coming months, raising risks of a recession.

Businesses whittled down inventories in the fourth quarter but they were rebuilt in the first quarter. Without the positive 0.8 percentage point contribution from inventories, the economy would have contracted in the first quarter.

The GDP report showed that final sales to domestic purchasers weakened in the first three months this year at the steepest rate in 16 years, which raises odds that businesses will have to lower output to sell those inventories off.

Some companies, like General Motors Corp. GM.N have already announced cuts in production. GM said earlier this month it will cut 2008 truck production by 138,000 vehicles.

"We expect that the coming inventory correction will send growth into negative territory, save a truly heroic effort by the U.S. consumer to spend their way out of the current malaise with their $600 rebates," said Joseph Brusuelas, U.S. chief economist at IDEAglobal in New York.

Tax rebates that are part of a government economic stimulus program began to flow this week to upwards of 100 million Americans.

While the Fed's policy-setting Federal Open market Committee lowered rates as expected, it also indicated it now wants to pause in its rate-cutting campaign. It said that it has put in place a "substantial easing of monetary policy" that should support moderate growth ahead.

The Fed has cut its benchmark federal funds rate by 3-1/4 percentage points since mid-September to 2 percent to shore up the economy and calm unsettled financial markets.

UNSETTLING PRICE RISES

The Fed specifically noted that energy and commodity prices were rising and inflation expectations were up -- all reasons to avoid reducing rates again unless forced to do so.

GDP is the broadest measure of total economic activity within U.S. borders. Many of the first-quarter report's details implied weakening that analysts fear will lead to a recession.

The GDP figures are an initial measure of first-quarter performance and will be revised twice in coming months.

Consumer spending that fuels two-thirds of economic activity through consumption of goods and services, grew at the weakest rate since the second quarter of 2001, when the economy was last in recession.

The weakening in an already distressed housing sector was even more striking. Spending on residential construction plunged at a 26.7 percent rate, the biggest quarterly drop since the end of 1981.

A separate report suggested the weakening labor market was keeping labor costs under wraps. The Labor Department said U.S. employment costs grew at a 0.7 percent annual rate in the first quarter, marking a slight slowdown from the fourth quarter.

Figures from the Mortgage Bankers Association on Wednesday suggested the housing market was far from recovery.

The MBA said its index of mortgage application activity dropped 11.1 percent last week to its lowest level since late December.

(Additional reporting by Mark Felsenthal and Lisa Lambert in Washington and Burton Frierson, Al Yoon and Richard Leong in New York; Editing by Andrea Ricci)