The economy stumbled badly in the first half of 2011 and came dangerously close to contracting in the January-March period, raising the risk of a recession if a standoff over the nation's debt does not end quickly.
Output increased at a 1.3 percent annual pace in the second quarter as consumer spending barely rose, the Commerce Department said on Friday. In the first three months of the year, the economy advanced just 0.4 percent, a sharp downward revision from the previously reported 1.9 percent gain.
"The economy essentially came to a grinding halt in the first half of this year," said Ryan Sweet, a senior economist at Moody's Analytics in West Chester, Pennsylvania. "We did get side-swiped by some temporary factors which are fading, but it raises some concerns about the sustainability of the recovery."
The weaker-than-expected second-quarter reading and downward revisions extending into last year underscored the frail state of the recovery, which economists said could fall off the rails if lawmakers do not raise the nation's $14.3 trillion borrowing limit and avoid a government default.
Consumer spending, which accounts for about 70 percent of U.S. economic activity, decelerated sharply in the second quarter, advancing at only a 0.1 percent rate -- the weakest since the recession ended two years ago.
Stocks on Wall Street fell on the data and the debt impasse on Friday, to record their worst week in a year. Prices for government debt rallied, while the dollar fell broadly.
The Obama administration has said it will run out of borrowing authority on Tuesday and could soon run out of cash, but talks aimed at raising the debt ceiling remain deadlocked.
"This should wake up those in Washington who still have their thinking caps on," said Joel Naroff of Naroff Economic Advisors in Holland, Pennsylvania. "There is no margin for error and a default that lasted any length of time could push us back into recession."
But any debt agreement would include budget cuts that could also weigh on growth. High Frequency Economics said in a note on Thursday that a deal to trim the U.S. deficit would likely shave government spending by about $70 billion, or one-half of a percentage point of GDP, in its first year.
Growth in the first half of 2011 was held back by a combination of bad weather, expensive gasoline and supply chain disruptions after the earthquake disaster in Japan.
With economic activity yet to show signs of perking up, even with gasoline prices off their highs and the Japan supply constraints easing, there is concern that some of the weakness might be fundamental and linger for a while.
While economists still expect growth to accelerate to about a three percent pace for the remainder of this year and next year, the risks are stacked to the downside.
Annual revisions to GDP data that take into account newly available source material, including tax returns, showed the economy lost steam in late 2010, before it ran into the temporary headwinds. Fourth-quarter growth was revised to a 2.3 percent rate from 3.1 percent.
The revisions also showed the 2007-2009 recession was much more severe than prior measures had found.
The downgrades help to explain why the economy has only regained a fraction of the more than 8 million jobs lost during the downturn.
Economists said the current bout of weakness reinforced views that the Federal Reserve will maintain its accommodative monetary policy stance for a while, but few think the central bank will spring to the economy's rescue if it can avoid it.
"In the immediate environment, with so much at stake on fiscal policy, I think the Fed wants to remain quietly on the sidelines, sorting out events and how the data plays out in the second half of the year," said Robert DiClemente, chief economist at Citigroup in New York.
JOLT FROM JAPAN
The U.S. central bank has held interest rates close to zero since Dec. 2008, and it has bought $2.3 trillion in bonds in an effort to further spur the economy. Fed Chairman Ben Bernanke has opened the door to a further easing of monetary policy, but officials have said they are hesitant to act.
"It's a very high bar," Atlanta Federal Reserve Bank President Dennis Lockhart told CNBC on Friday.
The March earthquake in Japan severely disrupted U.S. auto output, which subtracted 0.12 percentage point from GDP growth in the second quarter.
The decline, combined with high gasoline prices weighed on retail sales as consumers were unable to find the vehicle models they wanted.
Future spending strength will depend on employment and confidence. So far, the immediate outlook is not promising.
The Thomson Reuters/University of Michigan's index of consumer sentiment fell to 63.7 in July from 71.5 in June, a separate report showed.
But economists are cautiously optimistic the jobs market will have started to improve somewhat in July after faltering badly in the last two months, although U.S. companies are still trying to hold the line on hiring to save costs.
Merck & Co said on Friday that it plans to slash thousands of jobs by late 2015 to wring out savings of up to $1.5 billion a year.
Nonfarm jobs likely rose 90,000 in July, according to a Reuters survey, after June's paltry 18,000 gain.
Growth in the second quarter was supported by a smaller trade deficit, a pick-up in home building and a healthy rise in business spending. Most encouraging was a lack of a big build-up in business inventories, which rose only modestly.
"Inventory building does not seem to be overdone, which sets us up for a good boost from manufacturing in the second half," said Moody's Analytics' Sweet.
Government spending was another drag on growth in the second quarter. Overall inflation slowed during the quarter, but underlying price pressures continued to build.