Economy hits pothole, but likely to avoid ditch

News Analysis

(MoneyWatch) One takeaway from the sharp contraction in U.S. economic growth in the final three months of 2012: The sky isn't falling.

Although the headline number of 0.1 percent annualized growth for the period might sound alarming, the decline is attributable to temporary factors, economists said. And the Federal Reserve, while announcing its decision to leave interest rates unchanged Wednesday afternoon, blamed the slowdown on  "weather-related disruptions and temporary factors."

After surging in the August-to-September quarter, defense spending late last year plunged more than 22 percent, slicing 1.3 percent off overall GDP. Businesses also reduced their stockpiles, reducing growth by an additional 1.3 percent.

The upshot? Economic growth of 3.1 percent in the third quarter likely overstated the strength of the economy, while the latest data appears to understate it. Many experts predict that the economy will continue to idle in the early months of 2013 before picking up speed in the second half of the year.

Investors seemed unfazed by the downturn, with stocks largely flat in early afternoon trade.

"It would be a mistake to view this drop in GDP -- driven by temporary corrections in defense spending and inventories -- as a possible harbinger of recession," said Nigel Gault, chief U.S. economist for IHS Global Insight, in a research note. "The incoming data points to continued growth, and we expect GDP growth to rebound to around 2 percent in the first quarter."

Capital Economics also characterized the downturn as a blip, describing it as "the best-looking contraction in GDP you'll ever see." The research firm notes that personal consumption and income grew at a healthy clip toward the end of the year. Business spending on software and other equipment, another key driver of the economy, also rose 8.4 percent. That suggests companies are planning for decent, if not outsized, growth.

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Economist Dean Baker of the Center for Economic and Policy Research points to another ray of light in the latest Commerce Department figures: Spending on health care in the U.S. -- the main reason, along with the housing bubble, that the federal deficit has risen in recent years -- is slowing. The amount of money people shell out on doctor's visits and other medical services is now growing less quickly than the rest of the economy. 

"It seems increasingly likely that we are on a slower health care cost trajectory," Baker said in a report, adding that this will shrink the deficit when federal budget staff incorporate the data into their forecasts.

Not that the economy looks set to take off. A 2 percent hike in payroll taxes that kicked in on January 1 is likely to pare consumer spending in the first half of the year. The Conference Board, a trade association for businesses, said this week that slimmer paychecks are denting consumer confidence, which could curb spending and hinder the recovery.

Job growth also remains considerably weaker than normal following a recession. The economy added 192,000 jobs in January, according to a reading Wednesday of private-sector job-creation. Such growth won't do much to reduce unemployment from its current rate of 7.8 percent, but "it doesn't indicate that the economy is plunging headlong into another recession," said Paul Ashworth, chief U.S. economist for Capital Economics, in a research note.

The biggest unknown remains the outcome of congressional jockeying in Washington over mandated government spending cuts. That "sequester," the result of a 2011 compromise among Democrats in Republicans as part of a deal to raise the government's borrowing limit," could severely harm growth by removing more than $100 billion in federal spending quickly, beginning in March.