THE U.S. ECONOMY CONTINUED

to expand at a healthy pace during the second quarter while inflation remained squarely in check, according to a just-released report from the Commerce Department.

Gross domestic product expanded at an annual rate of 3.4% from April to June, a hair below consensus estimates of 3.5% and down a bit from 3.8% during the first quarter. GDP is a measure of all goods and services produced in the U.S. Meanwhile, the chain deflator, a reading of inflation released along with the GDP numbers, fell 2.4%, less than consensus estimates of 2.6% and down from 3.1% in the first quarter.

Taken together, analysts say, the GDP and deflator suggest that the economy is still growing at a solid rate. "In a way, this really is kind of the Goldilocks economy," says Bill Cheney, chief economist at John Hancock Financial Services in Boston. "It's not too hot, not too cold."

Despite the mostly positive data, investors were cool to the GDP report. Near midday, all of the major indexes had dipped slightly into the red.

The latest economic readings come in the middle of a strong earnings season, as the majority of companies in the S&P 500 reporting to date have beaten consensus estimates. Many have also reported better-than-expected revenues, which is consistent with the report. Real final sales grew 5.8% during the second quarter.

The report is also in line with the Federal Reserve's summary of local economic conditions, known as the Beige Book, which was released Wednesday. "Reports from all twelve Federal Reserve Districts indicate that economic activity continued to expand in June and early July," according to the report. "Most Districts reported increases in retail sales, and vehicle sales in nearly all Districts were boosted by a new round of price discounting."

The main drag on the economy came from a sharp decline in private inventories, which knocked 2.32 percentage points off the GDP, according to the report. American businesses slashed inventories by $6.4 billion during the second quarter. In the first quarter, inventories rose $58.2 billion.

"Inventories shocked the living daylights out of most forecasts," says Anthony Chan. "No one expected inventories to come in this weak. [The number] just fell into a deep black hole, and now all we have to do is wait for it to come back up."

Chan says the auto industry was hit particularly hard by the inventory slowdown. This summer General Motors, Ford Motor and DaimlerChrysler offered all customers their employee discounts to spur sales. GM said on Wednesday the company would end the discount program and price 2006 models lower. Analysts say GM's inventories will have fallen well below average for July.

Joshua Feinman, chief economist at Deutsche Asset Management, Americas, says components of the report foreshadow a strong finish for the year. "You had the big inventory drag and very strong final sales," he says. "That suggests the underlying strength in the economy is really quite good. There's certainly not going to be a drag again before the end of the year. In fact, there might be a boost."

Cheney, of John Hancock, agrees. "On the whole, the outlook is reasonably healthy," he says. "The fact that the only weakness was in inventories suggests that they're going to be built up again over the next few quarters."

Feinman says the inventory slowdown is tied to a decline in U.S. imports, which fell 2% on the quarter. "I think some of the things that were not produced because of the inventory drawdown were [also] not imported," he says. Meanwhile, exports shot up 12.6%.

The housing market also grew even hotter, as residential investment expanded 11% in the second quarter, after an increase of 8.3% in first quarter. "I think we've all learned that betting against housing in an environment with low interest rates is a losing bet," Chan says.

The GDP report also contained extensive annual revisions dating back to 2002. The changes were minor but painted a slightly less rosy picture of the past few years. "At the margin, the revisions to the last three years were a little bit negative, in the sense that there was a little bit less growth and a little bit more inflation," Feinman says. "They suggest that the economy had a little less oomph in '02 and '03 and that helps reconcile, a little bit, why the labor market was slow to recover."

Last December, the Bush administration predicted that economic growth would lose some steam this year, slowing to 3.5% in 2005 from 4.2% in 2004. The pace for the first quarter at first appeared disheartening at 3.1% but was eventually revised to a relatively rosy 3.8%. The second quarter rate of 3.4% appears more in line with the White House's estimate, which was used in formulating the annual budget. Of course, it's probably just a matter of time before that number is revised, too.