July 31 (Bloomberg) -- The U.S. economy expanded less than forecast in the second quarter as the drag from housing and rising unemployment blunted the impact of federal tax rebates.

The economy grew at a 1.9 percent annualized rate after expanding 0.9 percent in the first quarter, the Commerce Department said in Washington. The report also showed a recession may have begun in the final three months of 2007, as gross domestic product was revised to show a contraction in the period.

Stocks dropped, Treasuries rallied and the dollar slid the most in 10 days. Growth may weaken in the second half as unemployment increases, with government figures tomorrow forecast to show a seventh straight month of payroll declines.

``For the second half of this year the economy is going to be under pressure -- the boost from rebates will fade, putting pressure on spending,'' said Ryan Sweet, an economist at Moody's Economy.com in West Chester, Pennsylvania. The revisions ``will probably raise the debate of whether or not the recession has actually started.''

Yields on benchmark 10-year notes fell to 3.96 percent at 9:40 a.m. in New York, from 4.05 percent late yesterday. The Standard & Poor's 500 Stock Index declined 0.6 percent to 1,276.07. The dollar dropped 0.5 percent to $1.5649 per euro.

Unemployment Claims

Separate figures today showed that initial claims for unemployment insurance soared to the highest level in more than five years last week. Claims jumped by 44,000 to 448,000, the Labor Department said.

The smallest trade deficit in seven years prevented the economy from shrinking again last quarter. The trade gap narrowed to a $395.2 billion annual pace, adding 2.4 percentage points to growth, the most since 1980. Excluding trade, the economy would have contracted at a 0.5 percent pace, the second decline in the last three quarters.

The annual benchmark revisions showed the U.S. may have slipped into a recession in the last three months of 2007 as consumer spending slowed more than previously estimated and the housing slump worsened. The economy shrank 0.2 percent in the fourth quarter last year, compared with a previously reported 0.6 percent gain.

First-quarter figures were also revised down to show a 0.9 pace of growth compared with a prior estimate of 1 percent, Commerce said.

Economists' Forecasts

Economists had forecast a 2.3 percent gain in second- quarter growth, according to the median of 79 estimates in a Bloomberg News survey. Projections ranged from a 0.9 percent increase to a 4.2 percent gain. The report is the first for the quarter and will be revised in August and September as more information becomes available.

Declines in growth in the revisions are reinforcing the recession signals sent by the loss of jobs so far this year. Still, a downturn is unlikely to be officially declared for months to come.

The National Bureau of Economic Research, the Cambridge, Massachusetts-based arbiter of economic cycles, defines a recession as a ``significant'' decrease in activity over a sustained period of time. The declines would be visible in GDP, payrolls, production, sales and incomes. The NBER usually declares a recession six to 18 months after it begins.

A Labor Department report tomorrow may show payrolls declined by 75,000 in July, bringing total job losses so far this year to over 500,000.

Housing Impact

The housing slump continued to hurt the economy, even as the decline moderated. Residential construction dropped at a 15.6 percent annual pace after dropping 25.1 percent in the first three months of the year. The decline detracted 0.6 percentage point from growth, the smallest reduction in more than two years.

Consumer spending last quarter grew at a 1.5 percent pace, less than anticipated, compared with a 0.9 percent gain in the January-to-March period that was the smallest in 13 years.

Most economists are forecasting the lift from the rebates will fade in the second half of the year. Retail sales rose 0.1 percent in June, less than forecast, indicating consumers may already have started to retrench at the end of the quarter.

Shoppers are hunting for bargains to stretch the buying power of the stimulus checks. Wal-Mart Stores Inc., the largest retailer, said same-store sales in June rose 5.8 percent, the biggest increase in four years, as costumers spent the rebate money on discounted gasoline and food.

Wal-Mart's Take

``At times like now, when the average American is struggling with the cost of everyday needs, price matters,'' Eduardo Castro-Wright, chief executive officer of Wal-Mart's U.S. stores division, told shareholders last month.

The price index in today's report rose at an annual rate of 1.1 percent, the smallest increase since 1998 and down from 2.6 percent in the first quarter.

The Federal Reserve's preferred inflation gauge, which is tied to consumer spending and strips out food and energy costs, rose at a 2.1 percent pace, down from 2.3 percent. Policy makers including Chairman Ben S. Bernanke have said a 1 percent to 2 percent increase is preferable.

Investors are betting the Fed will hold the benchmark rate unchanged at 2 percent at its Aug. 5 meeting, according to federal funds futures contracts. Bernanke on July 15 told congressman that the economy faced threats to both growth and inflation.

There are ``significant downside risks to the outlook for growth'' and ``upside risks to the inflation outlook have intensified,'' he told the Senate Banking Committee in Washington.

To contact the report on this story: Bob Willis in Washington bwillis@bloomberg.net

Last Updated: July 31, 2008 09:53 EDT