June 28 (Bloomberg) -- The U.S. economy expanded at an annual pace of 0.7 percent in the first quarter, the slowest in four years, and a gauge of inflation watched by the Federal Reserve was unexpectedly revised up.

The increase in gross domestic product compares with the 0.6 percent rate estimated last month and follows a 2.5 percent gain the last three months of 2006, according to a report from the Commerce Department issued today in Washington. The price measure rose at the fastest since the second quarter of 2006.

Last quarter was probably the low point for growth as the trade deficit narrows and businesses boost spending and rebuild inventories, economists said. The increase in prices suggests Fed policy makers, meeting today, will hold interest rates unchanged for months to come.

``This is what the Fed had been looking for -- that growth would be picking up from here,'' Julia Coronado, a senior economist at Barclays Capital Inc. in New York, said before the report. ``We're putting together a pretty strong quarter in the second quarter.''

Economists forecast first-quarter growth would be 0.8 percent, according to the median of 73 estimates in a Bloomberg News survey. Projections ranged from 0.5 percent to 1.5 percent annual growth. Today's report is the final of three growth estimates.

The Fed's preferred inflation measure, which is tied to consumer spending and strips out food and energy costs, rose at a 2.4 percent annual rate, faster than the 2.2 percent previously estimated. The new estimate reflected higher costs for medical services.

Higher Prices

Economists may boost forecasts for a report due tomorrow based on today's price revision. The Commerce Department's personal income and spending report was projected to show the price gauge rose 1.9 percent in the year ended May, easing within the 1 percent to 2 percent range preferred by policy makers such as Fed Chairman Ben S. Bernanke.

The policy-making Federal Open Market Committee will hold its target for the benchmark overnight-lending rate between banks at 5.25 percent for an eighth consecutive meeting today, according to the unanimous forecast of economists surveyed. The announcement is due at about 2:15 p.m.

``Core inflation now is probably still running above 2 percent going into today's FOMC meeting,'' said John Shin, an economist at Lehman Brothers Inc. in New York. ``That is significant. Inflation is still above the Fed's comfort zone.''

Fewer Americans filed first-time claims for unemployment benefits last week, signaling the labor market remains healthy, a Labor Department report today also showed. Initial jobless claims decreased by 13,000 to 313,000 in the week that ended June 23.

Trade Deficit

Today's GDP revision mainly reflected a narrower trade deficit than previously estimated.

The trade gap last quarter was $606.2 billion at an annual pace, compared with $611.8 billion estimated last month. Trade subtracted 0.8 percentage point from growth, rather than the 1 percentage point estimated last month.

Companies reduced stockpiles at a $4.2 billion annual pace last quarter, compared with previous estimates of a $4.5 billion reduction.

``The inventory correction is over and with that usually comes an acceleration of growth,'' Jonathan Basile, an economist at Credit Suisse Holdings in New York, said before the report. ``What was ailing the economy last year and early this year is really behind us.''

One part of the economy still reeling is housing. Spending on residential construction projects fell at a 15.8 percent annual pace last quarter, after contracting at a 19.8 percent pace in the fourth quarter. The drop subtracted 0.9 percentage point from growth.

Home Sales

Combined sales of new and existing home dropped to a 6.905 million annual pace last month, the lowest level in four years, according to figures from the Commerce Department and the National Association of Realtors. Builders broke ground on fewer homes last month and the drop in sales suggests the slump will persist, economists said.

``We continue to see weak, and perhaps deteriorating, market conditions,'' Stuart Miller, chief executive officer of Lennar Corp., said in a statement this week. ``We currently expect to be in a loss position in our third quarter.''

Miami-based Lennar, the largest U.S. homebuilder, reported an unexpected loss for the quarter ended May 31 and said losses may persist into the next three months. New orders last quarter dropped 31 percent even as incentives rose 77 percent.

Bernanke said this month that restrictions on the availability of mortgage credit may slow housing demand even more. At the same time, he and other officials have said the slump hasn't spilled over into other parts of the economy.

Spending Moderating

Consumer spending will probably cool this quarter as record gasoline prices siphon money away from purchases of other goods and services, economists said.

Spending, which accounts for more than two-thirds of the economy and grew at a 4.2 percent annual rate last quarter, will expand at about half that pace this quarter, according to the median estimate of economists surveyed earlier this month.

The rebound in growth this quarter is based on trade and inventories rather than stronger demand, so the improvement is unlikely to be sustained, according to Jan Hatzius, chief U.S. economist at Goldman.

``Economic growth in the first half of 2007 is shaping up to look much stronger than seemed likely a couple of months ago,'' Hatzius said in a June 22 note to clients. ``The caveat is that final domestic demand is softening, a development that could foreshadow a renewed slowdown later in the year.''

Business Investment

A report yesterday cast doubt on the strength of a rebound in business investment. Durable goods orders excluding transportation equipment unexpectedly dropped 1 percent in May, according to a report from Commerce.

Non-defense capital goods orders excluding aircraft, a proxy for future business investment, dropped 3 percent, and shipments of those items, used in calculating GDP, fell 0.2 percent, the report also showed.

Increases in business investment are key to sustaining the expansion now that consumer spending is cooling, economists said.

Today's GDP report included a revised look at corporate profits for the quarter. Earnings adjusted for the value of inventories and depreciation of capital expenditures, known as profits from current production, rose 1.4 percent. For all of last year, profits were up 21 percent.

To contact the report on this story: Courtney Schlisserman in Washington Cschlisserma@bloomberg.net

Last Updated: June 28, 2007 09:00 EDT