By Lucia Mutikani
WASHINGTON (Reuters) - The economy unexpectedly contracted in the fourth quarter, but analysts said there was no reason for panic given that consumer spending and business investment picked up.
Gross domestic product fell at a 0.1 percent annual rate, its weakest performance since the economy emerged from recession in 2009, the Commerce Department said on Wednesday.
If it were not for the hit from slower inventory growth and the deepest plunge in defense spending in 40 years, the economy would have grown at a respectable 2.5 percent rate. In addition, economists said Superstorm Sandy, which struck the East Coast in late October may have reduced GDP by about half a point.
"Obviously, the headline number is a bit jarring, but the underlying details of the report, by and large, are consistent with an economy that is growing probably at a trend basis of about two percent," said Michael Hanson, a senior economist at Bank of America Merrill Lynch in New York.
Economists polled by Reuters had expected GDP to rise at a 1.1 percent rate and none had predicted a contraction. While many were surprised by the drop in output, they were heartened by the acceleration in consumer spending and rebound in business investment, which pointed to some fundamental economic strength.
A second report, from payroll processor ADP, showed private-sector payrolls expanded by 192,000 jobs in January after increasing 185,000 in December, which also suggested the recovery's fundamentals were sound.
Faster jobs growth could help the economy weather the headwind of higher taxes and possible spending cuts. A payroll tax cut expired on January 1 and big automatic spending cuts are set to take hold in March unless Congress acts.
Federal Reserve officials, at the end of a two-day meeting, noted economic activity had "paused" due to weather-related disruptions and other "transitory factors." They expressed confidence the recovery would regain speed with continued monetary policy support, and they left in place their monthly $85 billion bond-buying stimulus plan.
Economists say a growth pace in excess of 3 percent would be needed over a sustained period to significantly lower high unemployment. For the whole of 2012, the economy grew just 2.2 percent, and a report on Friday is expected to show the jobless rate held at 7.8 percent for a third straight month in January.
The Fed's commitment to loose monetary policy pushed the dollar to a 14-month low against the euro. Prices for U.S. Treasury debt rose marginally, while stocks on Wall Street fell.
In the fourth quarter, the recovery had to deal with uncertainty over the so-called fiscal cliff of scheduled tax hikes and budget cuts, which hurt confidence even though households and businesses seemed to shrug off the worries.
Businesses, caught with too much inventory on their hands in the third quarter, slowed their stock building in the final three months of the year. That slowdown reduced GDP growth by 1.27 percentage points, the most in two years.
But with the pick-up in consumer spending in the fourth quarter, businesses now will need to replenish stocks, which should help lift growth early this year.
"Today's number actually leaves the economy relatively well-positioned heading into the first quarter," said Michael Feroli, an economist at JPMorgan in New York.
The GDP report showed government spending tumbled at a 6.6 percent rate, with defense outlays plunging at a 22.2 percent pace, the largest drop since the third quarter of 1972.
Defense spending is on a downward trajectory as the government winds down two wars, but it had jumped in the third quarter, setting up for a larger-than-normal decline in the final three months of the year.
Trade also cut into the economy, slicing a quarter of a percentage point off the change in GDP. Exports, which have been hampered by a recession in Europe, a cooling Chinese economy and storm and strike-related port disruptions, fell for the first time since the first quarter of 2009.
Caterpillar Inc, the world's largest maker of construction equipment, on Monday reported a sharp drop in quarterly profits, citing weak demand in China as one reason for the decline.
PLENTY OF POSITIVES
There were several bright spots in the GDP report.
For one, household income after taxes and inflation increased at a strong 6.8 percent rate. That allowed households to step up their saving, and the saving rate rose by more than a percentage point.
Consumers were also helped by slowing inflation. An inflation gauge in the report advanced at just a 1.2 percent pace, down from 1.6 percent in the third quarter. So-called core prices rose just 0.9 percent, the smallest gain in two years.
Consumer spending, which accounts for more than two-thirds of economic activity, rose at a 2.2 percent rate, accelerating from the prior quarter's 1.6 percent growth pace, while business investment rebounded after its first drop in 1-1/2 years.
The housing market was another positive.
Homebuilding grew at a 15.3 percent rate after notching a 13.5 percent growth pace in the third quarter. It added to growth last year for the first time since 2005.
"A turnaround in the housing market will be a key support to the economy this year, with homebuilding contributing to growth and higher home prices supporting consumer spending," said Stuart Hoffman, chief economist at PNC Financial in Pittsburgh.
(Additional reporting by Leah Schnurr in New York; Editing by Andrea Ricci and Tim Dobbyn)