WASHINGTON (Reuters) - The economy regained speed in the first quarter, but not as much as expected, heightening fears it could struggle to cope with deep government spending cuts and higher taxes.
Gross domestic product expanded at a 2.5 percent annual rate, the Commerce Department said on Friday, after growth nearly stalled in the fourth quarter. Economists had expected a 3.0 percent growth pace.
"It wasn't the bang-up start to the year we had hoped for, and the signals from March suggested that we will only decelerate from here," said Avery Shenfeld, chief economist at CIBC World Markets in Toronto.
Growth rebounded in the early part of 2013 but data ranging from employment to retail sales and manufacturing weakened substantially in March. It appears the factory sector slowed further in April and many forecasters expect the economy's softness to persist into the third quarter before a convincing revival emerges, given belt-tightening in Washington.
A 2 percent payroll tax cut expired at the start of the year and $85 billion in mandatory spending cuts, known as the sequester, started to take hold at the beginning of March.
Second-quarter growth is expected to come in around a 1 percent pace, with growth for the full year seen around a sluggish 2 percent, about the same as in the prior three years.
"It certainly seems like we are in store for a significantly lower rate of growth than we saw here in the first quarter," said Sam Bullard, a senior economist at Wells Fargo Securities in Charlotte, North Carolina.
Government spending has already been on a downward path.
In the first three months of the year, it fell at a 4.1 percent pace as defense outlays dropped sharply for a second straight quarter. It has now moved lower in 10 of the last 11 quarters.
"The decline in government spending over the past two quarters is the biggest six-month contraction since the Korean war ended," Paul Ashworth, chief U.S. economist at Capital Economics in Toronto said in a research note.
In the fourth quarter of last year, the economy had expanded at only a 0.4 percent pace.
A big part of the pick-up in activity in the first quarter was due to the filling up of silos by farmers after a drought last summer decimated crop output. Removing inventories, the growth rate was a tepid 1.5 percent, a slowdown from a comparable 1.9 percent in the fourth quarter.
Still, most areas of the economy contributed to growth, with the exception of government, the trade sector and investment by businesses in offices and other commercial buildings.
While consumer spending increased solidly, it came at the expense of saving, which does not bode well for the future.
A separate report showed worries about finances sapped consumer morale in April, offering another potentially troubling harbinger. The Thomson Reuters/University of Michigan's final reading on the overall index on consumer sentiment fell to 76.4 last month from 78.6 in March.
Stocks on Wall Street fell on the data, while prices for Treasury debt rose and the dollar weakened against the yen.
The GDP report, which also showed a deceleration in inflation, provided ammunition for the Federal Reserve to maintain its monetary stimulus. The U.S. central bank, which meets next week, is widely expected to keep purchasing bonds at a pace of $85 billion a month.
"It will give doves the upper hand at next week's Federal Reserve meeting," said Diane Swonk, chief economist at Mesirow Financial in Chicago. "Don't expect to see any tapering of asset purchases or a slowdown in the growth of the Fed's balance sheet anytime soon."
Consumer spending, which accounts for more than two-thirds of U.S. economic activity, rose at a 3.2 percent pace - the fastest since the fourth quarter of 2010.
The increase came despite the higher taxes and steeper gasoline prices. Households, however, had to cut back on saving as incomes dropped at a 5.3 percent rate, the steepest descent since late 2009.
The saving rate - the percentage of disposable income households are socking away - fell to 2.6 percent, the lowest since the fourth quarter of 2007, from 4.7 percent in the final three months of last year.
Despite the spike in gasoline prices, inflation pressures were benign. Inflation rose at a 0.9 percent rate, the smallest gain since the second quarter of 2012 and a sharp slowdown from the 1.6 percent pace logged in the fourth quarter.
A core measure that strips out food and energy costs rose at a 1.2 percent rate.
The lack of inflation should come as welcome relief for American households, but it could cause some nervousness at the U.S. central bank, which aims to keep inflation close to 2 percent.
Business spending on equipment and software slowed sharply, and homebuilding also moderated, although it marked an eighth straight quarter of growth. Housing added to GDP last year for the first time since 2005.
While exports rebounded, they were outpaced by a surge in imports, resulting in a trade deficit that cut off half a percentage point from output.
Editing by Andrea Ricci and Tim Ahmann