Jan. 31 (Bloomberg) -- The U.S. economy grew at the fastest pace in a year last quarter as declining energy costs helped power consumer spending and contain inflation, enhancing Federal Reserve Chairman Ben S. Bernanke's stature at the start of his second year.

Gross domestic product increased at an annual pace of 3.5 percent, the Commerce Department said in Washington today. That was more than forecast and up from a 2 percent pace in the prior three months. Other figures today showed manufacturing and construction still struggling to shake off a slowdown.

A consumer-spending spree during the holidays helped the economy overcome slumps in homebuilding and auto production that some economists said would derail the expansion. Stocks rose after the Fed, which left its benchmark interest rate at 5.25 percent today, said inflation has ``improved'' at the same time data have shown ``somewhat firmer economic growth.''

``Bernanke's call and the Fed's call on the economy has been right,'' said Nariman Behravesh, chief economist at Global Insight Inc. in Lexington, Massachusetts. ``They said the weakness would be temporary and that inflation would edge downward, and those have happened.''

Central bankers, in a statement accompanying the rate decision, said that ``readings on core inflation have improved modestly in recent months'' and that price pressures would likely ``moderate over time.''

``I think we can all agree the inflation news was the anxiety that caused some to actually argue they'd be tightening,'' said Robert Barbera, chief economist of ITG Inc. in New York. ``So the fact they're acknowledging that it looks a bit better is welcome news for both bonds and stocks.''

Higher Stock Prices

The Dow Jones Industrial Average increased 106 points, or 0.8 percent, at 2:40 p.m. in New York. The Standard & Poor's 500 Index rose 9.4 points, or 0.7 percent.

Today's report is the government's first estimate of the quarter's gross domestic product, the value of all goods and services produced. The figures will be revised in each of the next two months.

Economists expected a 3 percent gain in GDP last quarter, according to the median estimate of 77 forecasts in a Bloomberg News survey. Growth estimates ranged from 1.8 percent to 3.9 percent.

In other reports, the National Association of Purchasing Management-Chicago said today that its business barometer fell to 48.8 this month from 51.6 in December. A reading lower than 50 signals contraction. Construction spending dropped 0.4 percent in December as homebuilding fell by the most in four months, the Commerce Department also reported.

Wages and Benefits

Wages and benefits paid to American workers rose less than forecast last quarter, suggesting inflationary pressures in the labor market are contained, a separate report from the Labor Department showed. The employment cost index rose 0.8 percent after a 1 percent third-quarter gain.

``How long we can go with minimal pressures on labor costs is unclear given the continued strength in the economy and the limited worker availability,'' said Joel Naroff, president of Naroff Economic Advisors in Holland, Pennsylvania. ``But for now, it is not a problem.''

For all of 2006, the economy expanded 3.4 percent after growing 3.2 percent the previous year.

Treasury securities declined and the dollar rallied in the minutes after the GDP report. They later reversed course after the Chicago survey and construction figures were released.

Inflation Rate

The GDP report's price index rose at an annual rate of 1.5 percent, the smallest gain in more than three years, compared with 1.9 percent in the third quarter. A measure of prices tied to consumer spending dropped at a 0.8 percent annual rate, the first decline since 1961.

Central bankers, who will be finishing a two-day meeting later today, focus on a consumer-spending price gauge that excludes food and energy costs, which tend to be more volatile.

By that measure, prices rose at an annual rate of 2.1 percent, compared with a 2.2 percent gain in the previous three months. Bernanke is among policy makers that have said they would prefer a 1 percent to 2 percent increase.

Consumer spending, which accounts for about 70 percent of the economy, rose at an annual rate of 4.4 percent last quarter, compared with a 2.8 percent pace in the previous three months.

Coach Inc., the largest U.S. maker of luxury goods, last week raised its earnings and sales forecast for this fiscal year. January sales at the New York-based company are ``very strong,'' Chief Executive Officer Lew Frankfort said in a statement Jan. 23.

Housing Slowdown

Rising wages are taking the sting out of a housing slowdown that has caused home prices to stagnate. Homeowners had tapped increasing home values to boost spending during the five-year housing boom that peaked in 2005, economists said.

A smaller trade gap also gave the economy a boost. The trade deficit shrank to an annual $581.4 billion pace from $628.8 billion in the third quarter. The deficit added 1.6 percentage points to GDP, the most in 10 years.

Home construction fell at an annual rate of 19.2 percent last quarter, the most since 1991, after contracting by 18.7 percent in the previous three months. The decline subtracted 1.2 percentage points from fourth-quarter growth.

Business fixed investment, which includes spending on commercial construction as well as equipment and software, dropped at a 0.4 percent annual rate, after rising at a 10 percent rate from July through September. Spending on new equipment and software fell 1.8 percent, the most since the last three months of 2002.

Business Inventories

Companies added to stockpiles at a $35.3 billion annual rate last quarter after a $55.4 billion annualized third-quarter gain. The figures subtracted 0.7 percentage point from growth.

Many economists had projected a bigger slowdown in inventory accumulation, suggesting companies may need to continue trimming stockpiles in coming quarters.

Automakers General Motors Corp., Ford Motor Co. and DaimlerChrysler AG's Chrysler are all losing money and have been cutting North American production as their U.S. sales decline. Auto production subtracted 1.2 percentage points from growth last quarter, today's report showed.

Unseasonably warm weather may have temporarily boosted growth last quarter by sustaining activity in industries that ordinarily slow down during the cold months, said Chris Low, chief economist at FTN Financial in New York. The drop in construction, for example, may have been even larger without the help from the weather, some economists said.

Policy Meetings

The policy-making Federal Open Market Committee has kept its benchmark interest rate at 5.25 percent since August after 17 straight increases.

Fed Bank of Chicago President Michael Moskow, Fed Vice Chairman Donald Kohn, and Richmond Fed President Jeffrey Lacker have been among policy makers in the last month who indicated it's too early for the central bank to relax its guard on prices.

The U.S. economy, the world's largest was valued at an annual rate of $11.5 trillion after adjusting for inflation. Unadjusted for price changes, GDP rose at a 5 percent annual pace to $13.5 trillion in the fourth quarter and grew 6.4 percent for all of 2006.

To contact the report on this story: Joe Richter in Washington at Jrichter1@bloomberg.net

Last Updated: January 31, 2007 14:47 EST