What slowed this economy?

The government this morning released its initial estimate of the growth rate of

gross domestic product

(aka, the economy) during the third quarter. At 2.7%, it was pretty low. The average rate from 1995 to 1999 was 4%. And it was lower-than-expected. Economists polled by

Reuters

had forecast a rate of 3.4%, on average.

Let's have a look at what happened.

GDP has four components:

Consumer spending

is the biggest, accounting for about two-thirds of the economic activity that takes place in any given quarter.

Private investment

-- encompassing spending by businesses on plant and equipment, inventory accumulation by businesses, and housing construction -- accounts for about half of the balance.

Government spending

accounts for the rest. Finally, the growth rate is adjusted to take into account any change in the size of the

trade deficit

. Stuff produced elsewhere doesn't count toward GDP, so growth in the trade deficit subtracts from GDP, and narrowing of the deficit adds to GDP.

In the third quarter, consumer spending grew at a healthy 4.5% rate, up from 3.1% in the second quarter and in line with what most economists expected. That's faster than the 1995-99 average of 4.1%, but considerably slower than the 5.4% average over the previous four quarters. This is news that warms the heart of a

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Fed that is trying to engineer a gradual slowdown so that the inflation rate remains at tolerable levels. Consumer spending contributed about 3 percentage points to the overall third-quarter growth rate.

Private investment -- business spending on plant and equipment in particular -- accounted for much of the unexpected weakness in the report. Overall, private investment grew at a 3.2% rate, falling way short of the 9.3% average for 1995-99 and adding 0.6 percentage points to the overall growth rate. But, the overall private-investment growth rate averages together a number of disparate trends, including some fully expected weakness and some unexpected strength.

Housing construction, for example, slowed at a rate of 9.2%, a development economists expected after the housing boom of the previous two quarters. That subtracted 0.4 percentage points from GDP.

Meanwhile, businesses accumulated inventories at a faster pace during the third quarter ($79.9 billion) than they did during the second ($78.6 billion), adding 0.08 percentage points to the growth rate.

The surprising news in the private investment sector came from business spending on plant and equipment, which grew at a 6.9% rate, after posting double-digit rates in each of the previous two quarters. Economists were

predicting a much smaller slowdown to around 10%, which would have added more than 0.9 percentage points to the overall growth rate.

Rounding out the results, an expected pullback in government spending (after an extraordinarily large increase during the second quarter) subtracted 0.6 percentage points, and a slight expansion in the trade deficit sliced a quarter of a percentage point from overall third-quarter growth.

What does it all mean for the future? Economists highlighted three things.

First, that inventory accumulation will almost certainly slow, creating a drag on overall growth. "For the second consecutive quarter, inventories grew at a rate about twice as fast as what is sustainable,"

Barclays Capital

economist Henry Willmore wrote in a research note. "A slowdown in inventory growth is likely to prevent any significant rebound in GDP growth in coming quarters."

Second, that by the same token the big drops in residential investment (housing construction) and government spending, which together subtracted a full percentage point from GDP growth, are unlikely to be repeated. "These shifts were largely expected, and will probably be temporary,"

Daiwa Securities

chief economist Michael Moran said in a research note.

Finally, that the slowdown in business investment has mixed implications. "This is the one area of demand that policymakers would like to remain strong -- it is the source of the productivity gains that have helped the economy register its stellar performance," Moran observed. Productivity gains enable the economy to grow at a faster pace without leading to shortages and rising prices.

Inflation Remains in Check

The GDP report also contains a broad measure of the inflation rate, the so-called implicit price deflator, and it too was lower than economists expected at 2.0%, the lowest reading so far this year.

That, economists say, increases the likelihood that the Fed will continue to stand pat on interest rates. As long as most signs continue to point to moderating growth and a tolerable inflation rate, there is no reason for the Fed to hike interest rates and risk slowing growth too much.