The Commerce Department report showed gross domestic product, the measure of total goods and services output within U.S. borders, was dampened by the largest increase in imports in 26 years. Nonetheless, growth was not quite as weak as anticipated.
So far, analysts do not believe the economy will slide back into recession and say the most likely prospect is for continued soft expansion rather than a double dip downturn.
The outlook continues to be one of modest growth rather than double dip. The question remains whether subpar growth that fails to bring down the unemployment rate is a high enough bar for further Fed policy action, said Julia Coronado, an economist at BNP Paribas in New York.
Federal Reserve Chairman Ben Bernanke told monetary policymakers at their annual retreat in Wyoming the recovery had softened more than expected and reiterated the U.S. central bank was ready to take further steps if needed to spur growth.
The committee is prepared to provide additional monetary accommodation through unconventional measures if it proves necessary, especially if the outlook were to deteriorate significantly, he said.
A private survey showed consumer sentiment pulled back in late August from earlier in the month but still improved from late July.
Gross domestic product growth previously was estimated at 2.4 percent and analysts had feared it would be pushed down even more sharply. But robust business investment and a slight firming in consumer spending partially cushioned the blow from imports.
Analysts polled by Reuters had forecast GDP would be revised to a 1.4 percent growth rate. The economy grew at a 3.7 percent pace in the first three months of the year.
At midday, U.S. stocks were higher on the GDP report coming in stronger than expected and Bernanke saying the Fed would do what is needed to spur growth. But investors sold off government debt, taking profits on a recent run-up, and the U.S. dollar rose against the euro.
BAD POLITICAL OMEN
A slackening recovery poses a major political challenge for the Obama administration and the Democratic Party a little over two months away from crucial mid-term elections that could shift the balance of power in Congress in favour of Republicans.
A Reuters/Ipsos poll this week found Obama's approval rating at 45 percent, overtaken for the first time by a 52 percent disapproval rating.
While growth in the United States is slowing, output in other industrialized nations is holding up. Britain's economy grew at its fastest pace in nine years in the second quarter on strong construction activity. [ID:nLDE67Q0PR]
The U.S. economy's recovery from its worst economic downturn since the Great Depression had been largely fuelled by an $862 billion government stimulus package and businesses rebuilding inventories from record low levels.
A growing budget deficit makes it unlikely the government will inject more money into the economy to shore it up.
Growth in the last quarter was stifled by a 32.4 percent surge in imports, the largest since the first quarter of 1984, dwarfing a 9.1 percent rise in exports. That created a trade deficit, which sliced 3.37 percentage points from GDP, the largest subtraction since the fourth quarter of 1947.
The growth in imports is across the board. The strong demand for imports indicates there is pent up demand out there, but for growth it's negative because exports are not keeping pace, said Gus Faucher, director of macroeconomics for Moody's Economy.com in West Chester, Pennsylvania.
INVENTORY BOOST FADING
A smaller contribution from business inventories than initially estimated also restrained output. Business inventories increased only $63.2 billion, rather than the previously estimated $75.7 billion, adding a slim 0.63 percentage point to GDP.
Inventories, which had been a major driver of the recovery that started in the second half of 2009, increased $44.1 billion in the first three months of the year.
Excluding inventories, the economy expanded at a 1 percent rate, instead of the 1.3 percent pace reported last month.
There were some bright spots in the report, with growth in consumer spending revised up to a 2 percent rate from 1.6 percent. Consumer spending grew at a 1.9 percent rate in the first quarter.
Stubbornly high unemployment has dampened consumer spending and added 1.38 percentage points to GDP last quarter.
Although businesses have been reluctant to hire new workers, they have been splurging on equipment and software, which also contributed to the surge in imports. Business investment was revised up to a 17.6 growth percent rate, the largest increase since the first quarter of 2006, from the previously estimated 17 percent pace.
Investment in equipment and software was the strongest since the fourth quarter of 1983.
Growth in new home construction was revised down slightly to 27.2 percent from 27.9 percent. The sector, which was a drag on growth in the first quarter, was lifted by a spurt in building activity spurred by a popular home-buyer tax credit, which has since expired. The rate of increase was still the biggest since the third quarter of 1983.
Residential investment had contracted at a 12.3 percent rate in the first quarter.
The report also showed corporate profits rose 2.9 percent in the second quarter after increasing 5.8 percent in the first three months of the year.
(Reporting by Lucia Mutikani; Editing by Neil Stempleman and Dan Grebler)