Sharp slowdown in US growth eases pressure for rate rises

American businesses dramatically slowed the pace of new investment over the spring, raising the spectre of a sharper than expected economic slowdown.

The US economy grew 2.5 per cent in the second quarter of the year, well below forecasts and triggering a sell-off of the dollar and a surge in the bond market.

But stock markets rallied, in the belief that the Federal Reserve will be forced to call a halt to more than two years of interest rate rises when it meets next on 8 August.

Wall Street had expected the US economy to slow from its rate of 5.6 per cent in the first quarter to about 3.2 per cent in the three months to the end of June, as consumers tightened their belts to cope with higher petrol prices.

Consumer spending on costly durable goods like new cars, export growth, government spending and housing investment all weakened. And business investment also slowed sharply. At 2.7 per cent, the level of growth was the slowest in more than two years, with companies cutting back in particular on new equipment and software.

"The GDP number was softer than expected and it increases the chances that the Federal Reserve will pause in their long string of interest-rate increases when they meet next in August," Alan Gayle, a senior investment strategist at Trusco Capital Management, said. However, the market may begin to worry about "too rapid a deceleration" in economic growth, he said.

The Dow Jones Industrial Average surged more than 100 points in the first hours of trading, a rally that was reflected in markets around the world. The Dow closed 119.3 points higher at 11,219.77. In London, the FTSE 100 closed up 45.4 at 5,974.9 points, its highest close since 12 May.

The US bond market is now pricing in rate cuts next year, but other economic indicators published yesterday suggested continued inflationary pressures and compound the dilemma for the Federal Reserve chairman, Ben Bernanke.

US labour costs rose 0.9 per cent in the last quarter, led by the biggest increase in wages in three years. The rise followed a 0.6 per cent gain in the previous three months. And the government's personal consumption expenditures index, a measure of prices tied to consumer spending, rose at a 4.1 per cent rate after a 2 per cent rise in the first quarter. The index excluding food and energy, the measure favoured by Fed policymakers, rose at a 2.9 per cent annual rate, up from 2.1 per cent.

Mr Bernanke told Congress last week that he expected softer growth to restrain inflation over time.