July 27 (Bloomberg) -- The U.S. economy grew more than forecast last quarter, propelled by rising exports, commercial construction and government spending.

The 3.4 percent annual pace of expansion, the most in more than a year, followed a revised gain of 0.6 percent in January to March, the Commerce Department reported today in Washington. The Federal Reserve's preferred inflation gauge rose at the slowest pace in four years.

Spending on commercial construction projects rose at the fastest pace in 13 years, helping to overcome another drop in homebuilding. Factories ramped up production to fill orders from Europe and Asia that made up for a slowdown in consumer spending. Treasury securities erased gains, stock-index futures trimmed losses and the dollar remained higher.

``The good news is that capital spending and exports are growing,'' said Nariman Behravesh, chief economist at Global Insight Inc. in Lexington, Massachusetts. Still, ``the economy is plodding along. We're very vulnerable to a shock.''

The yield on the benchmark 10-year note rose to 4.80 percent at 9:15 a.m. in New York, compared with 4.79 percent late yesterday. Stocks were mixed in early trading after plunging the most in five months yesterday.

Economists forecast a 3.2 percent gain in second-quarter GDP, according to the median of 85 estimates in a Bloomberg News survey. Projections ranged from 2.2 percent to 4.1 percent.

The report's price index rose at an annual rate of 2.7 percent, down from 4.2 percent in the first quarter.

Inflation Cooled

The Fed's preferred inflation gauge, which is tied to consumer spending and strips out food and energy costs, rose 1.4 percent, down from 2.4 percent. Policy makers including Chairman Ben S. Bernanke have said a 1 percent to 2 percent increase is preferable.

``The Fed should be pretty happy with these numbers,'' said David Wyss, chief economist at Standard & Poor's in New York. ``I don't think the Fed does anything this year.''

The report is the first for the quarter and will be revised in August and September as more information becomes available. The first quarter's growth rate was the weakest since 2002.

American consumers, who kept the economic expansion alive in the first three months of the year, were a weak spot last quarter. Consumer spending, which accounts for about 70 percent of the economy, slowed to a 1.3 percent annual pace, the weakest since the last three months of 2005, from 3.7 percent the previous three months.

Consumers Spending Less

The slowdown in consumer spending makes it more likely that the second quarter will prove to be the strongest of the year, economists said.

The trade deficit narrowed to an annual pace of $577.9 billion last quarter from $612.1 billion. The smaller gap added 1.2 percent to growth, after subtracting 0.5 percent the prior quarter.

Manufacturers are benefiting from the gain in overseas demand. Eaton Corp., the world's second-largest maker of hydraulic equipment, last week increased its annual profit forecast.

``While the consumer side is a little weaker, there's real strength in the manufacturing side,'' Alexander Cutler, chief executive officer of Eaton, said in a July 16 interview. ``The lower value of the dollar means it's a great time to export from the U.S.''

Business fixed investment, which includes spending on commercial construction as well as equipment and software, rose at an 8.1 percent annual rate, after increasing at a 2.1 percent rate the prior quarter.

Commercial Construction

Investments in new structures, such as factories, warehouses and office buildings, rose at a 22 percent pace, the most since 1994. Spending on new equipment and software increased at a 2.3 percent pace.

A Commerce report yesterday cast doubt on the strength of business spending on new equipment in coming quarters. Orders for durables goods excluding transportation equipment unexpectedly fell in June.

``There is no momentum entering the third quarter,'' Josh Shapiro, chief U.S. economist at Maria Fiorini Ramirez Inc. in New York, said before the report.

Businesses were still reluctant to expand stockpiles. Companies added to stockpiles at a $3.6 billion annual rate last quarter after a $100 million annualized first-quarter gain. The figures added 0.2 percentage point to growth. Some economists had predicted inventories would add as much as a full percentage point to GDP.

Residential investment fell at an annual rate of 9.3 percent last quarter, after contracting by 16 percent in the previous three months. That took away 0.5 percentage point from economic growth, compared with a 0.9 percentage point reduction in the first quarter.

Housing to Decline

Some economists have ruled out a rebound in housing this year as subprime mortgage defaults and foreclosures mount and home sales drop. New-home purchases last month fell 6.6 percent, the most since January, Commerce reported yesterday.

``Most housing indicators have deteriorated in recent months, which points to a potential 'double dip' in the contribution of residential investment to GDP growth,'' Jan Hatzius, chief U.S. economist at Goldman, Sachs & Co. in New York, said before the report.

The Fed last week trimmed growth forecasts for this year because of the lingering slump in housing. The economy will grow by 2.25 percent to 2.5 percent in the fourth quarter of 2007 from a year before, compared with a range of 2.5 percent to 3 percent given in February, the Fed said.

The Commerce Department today also revised GDP going back to the first quarter of 2004. The world's largest economy grew an average 3.2 percent from 2004 through 2006, 0.3 percentage point slower than previously thought. Prices were little changed from earlier estimates. The updates reflect more complete information derived from business surveys and data from the Internal Revenue Service.

To contact the reporter on this story: Shobhana Chandra in Washington at schandra1@bloomberg.net

Last Updated: July 27, 2007 09:35 EDT