By Glenn Somerville
WASHINGTON (Reuters) - The U.S. economy suffered its sharpest contraction in seven years in the third quarter as consumers cut spending and businesses reduced investment at the onset of what may be a severe and long-lasting recession.
The Commerce Department said on Thursday that U.S. gross domestic product shrank at a 0.3 percent annual rate as the biggest pullback by consumers since 1980 overwhelmed an increase in government spending.
San Francisco Federal Reserve Bank President Janet Yellen called the economy's recent performance "deeply worrisome," and said the downturn was set to worsen.
"For the fourth quarter, it appears likely that the economy is contracting significantly," Yellen said, adding "the bottom is not yet in sight" for slumping housing prices.
The typical definition of a recession is consecutive quarters of shrinking national output, a condition that would be met if fourth quarter GDP declines as anticipated, though analysts already expect the slump to last nine months or more.
The drop in GDP was widely expected but the decline was not as great as feared, soothing the angst of investors who bid U.S. stocks up in the hope that interest-rate cuts by central banks around the globe can ward off a deeper downturn.
Despite the date, the blue-chip Dow Jones industrials <.DJI> ended the day up 2.1 percent.
American voters go to the polls on Tuesday to elect the next U.S. president, and a run of gloomy economic news has given Democratic candidate Sen. Barack Obama an edge over Republican rival Sen. John McCain in the polls.
While the White House conceded the economy had "weakened substantially," it insisted measures it has initiated, like a plan to buy troubled mortgage assets from banks, should help ease credit-market woes, which have cast a cloud worldwide.
Paul Ashworth, senior U.S. economist for London-based Capital Economics Ltd, said he now expects the U.S. economy to shrink 1.5 percent next year, with no growth in 2010.
"Overall, we expect the level of GDP to shrink by a total of 2.5 percent, which would make this one of the worst recessions since the Great Depression," Ashworth said.
CONSUMERS FALTER
Speaking in Florida, Obama said McCain would continue the policies of President George W. Bush, which have landed the economy in trouble. "George Bush has dug a deep hole for us and he wants to hand the shovel to John McCain," he said.
But McCain adviser Carly Fiorina said the GDP data was no surprise and the Republican candidate had the right economic prescription.
"I think that people have been expecting it now that we would be going into a recession for some time," she told reporters in Ohio, adding that lower capital gains taxes and investment incentives were needed to spur job creation.
The third-quarter contraction was a striking turnaround from the second quarter's relatively brisk growth rate of 2.8 percent, a pace supported by a shot of government stimulus.
Consumer spending, which fuels two-thirds of U.S. economic activity, fell at a 3.1 percent rate in the third quarter -- the first drop since the closing quarter of 1991. Spending on nondurable goods -- items like food and paper products -- shrank at the sharpest rate since late 1950.
Heavy government spending, still-strong export growth and a slower pace of inventory liquidation helped mask the extent of deterioration in other sectors.
"The bad news is the private sector was doing really badly," said Nigel Gault, chief U.S. economist at Global Insight in Lexington, Massachusetts. "Consumer spending, equipment and software, residential -- the whole private side was very weak."
STRESS MOUNTS
Continuing job losses, coupled with declines in the value of stocks and homes, have put consumers under severe stress.
The report showed that disposable personal income dropped at an 8.7 percent rate in the third quarter -- the steepest on record, dating to 1947 -- after economic stimulus payments helped push it ahead at an 11.9 percent clip in the second quarter.
Separately, the Labor Department said weekly claims for new unemployment benefits were unchanged at a lofty 479,000 last week, a level that signals weak hiring prospects.
The U.S. economy has shed jobs in each of the last nine months, with about 750,000 lost so far. On Thursday, American Express
Mass layoffs -- involving 50 or more people -- hit their highest level since September 2001 last month.
In the third quarter, spending on durable goods like cars and furniture fell at a 14.1 percent annual rate, the steepest drop since the beginning of 1987, while businesses cut investment spending for the first time since the end of 2006.
In contrast, federal government spending shot up at a 13.8 percent annual rate, the strongest gain since the second quarter of 2003 when the war in Iraq began.
Prices rose strongly in the third quarter, with a gauge of prices on items consumers bought up at a 5.4 percent annual rate, the sharpest since early 1990. But oil prices peaked in July and many other commodity prices have also begun to ease, signaling a big shift in the inflation outlook.
(Additional reporting by Jim Christie in Berkeley, California, Ros Krasny in Chicago and Alister Bull in Washington; Editing by Gary Crosse)
