The U.S. economy slowed sharply in the fourth quarter. U.S. GDP increased at an annual rate of just 0.7% according to advance estimates released by the Bureau of Economic Analysis. In the third quarter, real GDP increased 4%.

Economists say that the weak GDP was expected, and that the U.S. economy is stronger than this number suggests.

“The ‘soft spot’ for the U.S. economy lived up to its name, as there wasn’t a lot to cheer about in Q4’s scant 0.7% annualized real GDP growth rate,” says CIBC World Markets. “Defense spending account for all but 0.2% of that gain, and add in the contribution from other government spending, with other government buying making up all of the rest of the growth. The only bright spot was that business capital spending finally stopped falling after a two-year recession.”

BMO Nesbitt Burns says that the details of the report are much stronger than the headline result. “The revival of capital spending for equipment and software continued for the third quarter running. We have confidence that this trend will be maintained in the new year and this is a key reason for optimism. And, housing and federal government spending remain strong sources of support.”

RBC Financial Group economists agree that the news is not all bad. “Businesses added to investments in machinery, equipment and software for the third straight quarter in to close to 2002. While geopolitical risks are playing havoc with business confidence, it appears that improving business fundamentals have begun to assert themselves more solidly. While yet to be reported for the fourth quarter, third quarter economy wide business profits before taxes had climbed back to pre-recession levels along with the inventory-to-sales ratio in the fourth quarter. Growth in consumer spending this year is likely to yield a long awaited increase in employment this year as production gears up to satisfy demand and replace inventory stocks once geopolitical risks subside.”

The foreign trade sector and slower inventory building account for the slippage in growth, BMO insists. “Trade problems partly reflected the dock strike and, viewing the dollar’s decline, it is possible trade will be less of a drag this year. An inventory turnaround may already be cooking on the back burner, if the ISM surveys are reliable guides.”

“If war breaks out in a month or so, as now seems likely, markets will likely be keying on the ex-defense growth rate for the US economy. We look for that figure to run at just under a 3% pace as inventories and consumer spending register better showings. But that is likely to prove no more lasting than the two similar pick-ups seen in 2002 (in the first and third quarters respectively), with business investment failing to take off and household spending not backed by sufficient job growth,” concludes CIBC.

In other data, initial jobless claims rose by 14,000 last week to a one-month high of 397,000. The less volatile 4-week moving average fell, however, for the fourth straight week by 3,000 to 384,000.

“The labour market is a coincident to lagging indicator and is only expected to firm-up sometime in the second quarter of 2003 alongside some stronger economic numbers,” says RBC. And, the U.S. employment cost index slowed to 0.7% in the fourth quarter, slightly less than the 1.0% increase foreseen by markets. “Clearly, the weakening of employment costs does imply weaker income growth, which obviously has troubling implications for U.S. consumer spending over the near term,” it says.

BMO concludes that the U.S. economy is maintaining more momentum than the headline GDP number suggests.

“Today’s GDP report was not unexpected by markets nor the Fed,” says RBC. “Our view remains unchanged that policy rates will only begin to rise modestly this year towards year-end after the recovery in the U.S. is more firmly established.”