Aug. 14 (Bloomberg) -- Germany and France, the euro area's two largest economies, contracted in the second quarter as faltering sales undermined investment by companies and soaring costs eroded consumer spending power.

German gross domestic product fell a seasonally adjusted 0.5 percent from the first quarter, when it rose a revised 1.3 percent, the Federal Statistics Office in Wiesbaden said today. In France, GDP declined 0.3 percent, reversing a 0.4 percent gain in the previous three-month period.

The stronger euro and slower global growth have damped demand for euro-area exports just as faster inflation erodes domestic purchasing power. Confidence in Europe's economy has fallen to the lowest in almost 15 years and European Central Bank President Jean-Claude Trichet last week said growth will be ``particularly weak'' through the third quarter.

``There are two factors here: a correction from the strong first quarter and an underlying slowdown,'' said Aline Schuiling, an economist at Fortis in Amsterdam. ``The first-half picture is of moderate growth and it is going to remain weak in the euro zone for the remainder of the year.''

The euro-area economy probably shrank by 0.2 percent in the second quarter from the first, when it expanded 0.7 percent, according to the median estimate of 40 economists in a Bloomberg News survey. The data will be published at 11 a.m. today.

Even with the weaker growth, the ECB last month raised its key rate to 4.25 percent, a seven-year high, to curb inflation. German consumer prices rose 3.5 percent in July from a year earlier, the statistics office said today, revising up its initial 3.4 percent estimate. European inflation quickened to 4.1 percent last month, more than twice the ECB's 2 percent limit, according to a first estimate on July 31.

Slowest Pace

Spain's economy grew at the slowest pace since a 1993 recession in the second quarter as the country's once-booming construction industry slumped, according to separate figures today. Italy's economy, the third-biggest in the euro region, unexpectedly shrank in the April-June period, edging closer to a fourth recession in a decade.

An index measuring the economic climate in the euro region dropped to the lowest since 1993, the Munich-based Ifo institute said yesterday. Measures of both current conditions and expectations declined, according to institute's quarterly World Economic Survey.

The economic slowdown isn't confined to the euro area. The Bank of England yesterday cut its forecast for U.K. economic growth as unemployment rose the most in almost 16 years. The central bank's governor, Mervyn King, also said there is the ``possibility of a quarter or two of negative growth.''

Global Growth

In China, industrial production expanded in July at the slowest pace since February 2007, as cooling global growth curbed orders for goods and higher fuel and raw-material prices deterred some companies from expanding.

Trichet, speaking last week after the ECB kept its benchmark rate at 4.25 percent, said the central bank has ``no bias'' on interest rates and he removed a reference from his introductory statement to ``moderate, ongoing growth.''

While oil prices have retreated 20 percent from a record $147.27 a barrel reached on July 11, they are still 60 percent higher than a year ago. The euro, which rose to a record $1.6038 on July 15, has gained 10 percent in the past 12 months.

Ryanair Holdings Plc, Europe's biggest discount airline, last month said it may post the first full-year loss since going public in 1997 on higher fuel costs.

`Real Slowdown'

``The real slowdown is only starting now,'' said David Kohl, deputy chief economist at Julius Baer Holding AG in Frankfurt. ``The worst is still ahead.''

Cooling growth has prompted investors to start to price in interest-rate reductions. Yields on Eonia forward contracts, a widely used market gauge of interest-rate expectations, have fallen in the past month. The yield on the March contract dropped to 4.14 percent today from 4.38 percent a month ago.

German factory orders have fallen for the past seven months and dropped the most in a year in June, according to figures published last week. An index of European manufacturing and services activity fell to 47.8 last month from 49.3 in June, where below 50 indicates a decline.

Some companies are trying to offset falling western European and U.S. orders by expanding in eastern Europe, oil- exporting countries and emerging Asia. Hochtief AG, Germany's largest builder, today reported a jump in second-quarter profit and increased its full-year forecasts on rising demand for construction and mining work in Australia and Asia.

In Germany, the second-quarter contraction was exacerbated by companies bringing forward investment in construction due to unusually mild weather in the first three months of the year. The decline in GDP, better than the 0.8 percent median forecast of 41 economists surveyed by Bloomberg, was mostly due to a drop in construction, capital investment and consumer spending, the statistics office said.

The French contraction was unexpected, as economists had expected 0.1 percent growth.

To contact the reporters on this story: Fergal O'Brien in Dublin at fobrien@bloomberg.net; Christian Vits in Frankfurt at cvits@bloomberg.net.

Last Updated: August 14, 2008 04:20 EDT