July 28 (Bloomberg) -- The U.S. economy grew at a below- forecast 2.5 percent annual rate last quarter, less than half the pace of the prior three months, strengthening speculation the Federal Reserve won't raise interest rates at its next meeting.

The first estimate of the quarter's gross domestic product, the value of all goods and services produced in the U.S., compares with a 5.6 percent gain in the first three months of the year, the Commerce Department reported today in Washington.

Consumers reined in spending as energy prices climbed, while business investment in new equipment fell for the first time in more than three years. Futures traders put the probability of a move when policy makers meet next month at 28 percent, down from about 90 percent last week.

``The consumer slowdown is really the heart of this,'' said Stephen Gallagher, chief U.S. economist at Societe Generale SA in New York. ``This is some slowing news that is likely to reinforce the Fed's hopes to stop rate hikes relatively soon.''

Economist Joe Carson said the report serves as a ``warning sign to the Fed'' because not since the first three months of 1991 has home construction, consumer spending on durable goods, and corporate purchases of equipment all declined in the same quarter.

With inventories rising at the same time, ``it shows a lopsided picture,'' said Carson, director of global economic research at AllianceBernstein Holding LP in New York.

Slower Growth

Treasury notes rallied and the dollar weakened. Fed Chairman Ben S. Bernanke told Congress last week that he is counting on a cooling economy to slow the rate of inflation in coming months. The expansion is unlikely to pick up much in the coming year, economists said.

Confidence among consumers waned this month, according to a survey by the University of Michigan. The university's sentiment index slipped to 84.7 this month, from 84.9 in June.

A separate report from the Labor Department showed U.S. labor costs rose 0.9 percent last quarter, more than expected and led by the biggest increase in wages in three years. The rise followed a 0.6 percent gain in the previous three months.

The government's personal consumption expenditures index, a measure of prices tied to consumer spending, rose at a 4.1 percent rate after a 2 percent rise in the first quarter. The index excluding food and energy, a measure favored by Fed policy makers, rose at a 2.9 percent annual rate after a 2.1 percent rise the previous quarter.

Emphasis on Slower Growth

``There's nothing in the core PCE number to make the market nervous that inflation is growing more than expected,'' said Ellen Zentner, an economist at Bank of Tokyo-Mitsubishi UFJ Ltd. in New York. ``The emphasis in this report is the economy growing slower rather than a focus on inflation.''

Treasury notes rose after the reports, pushing the yield on the 10-year note below 5 percent. The yield on two-year notes, which are more sensitive to central bank rates, dropped 7 basis points to 4.97 percent. Stocks gained on optimism the economy will keep expanding, though not at a pace troublesome to the Fed.

After the reports, traders saw a Fed rate increase as less likely at the next meeting on Aug. 8. The probability of the central bank raising its target for the main U.S. rate to 5.5 percent fell to 28 percent as of 10:09 a.m., from 44 percent yesterday, based on prices at the Chicago Board of Trade.

Consumer spending rose at an annual rate of 2.5 percent last quarter, as a slowdown in the housing market discouraged spending, compared with a 4.8 percent pace in the previous three months. Economists expected a 2.1 percent gain, based on the survey median. Consumer spending growth has averaged about 3.4 percent a quarter the past 30 years.

Government Revisions

With today's GDP report, the government also revised GDP data going back to the first quarter of 2003. The economy grew at an average annual rate of 3.2 percent from 2003 through 2005, or 0.3 percentage point less than previously estimated.

The value of all goods and services produced in the U.S., the world's largest economy, rose to $11.4 trillion in the second quarter after adjusting for inflation. Unadjusted for price changes, GDP rose to $13.2 trillion.

Business fixed investment, which includes spending on commercial construction as well as equipment and software, rose at a 2.7 percent annual rate in the second quarter, the smallest gain since early 2004, after rising 13.7 percent in January through March. Spending on new equipment and software fell 1.0 percent, the first decline since the first quarter of 2003.

Auto Production

A decline in motor vehicle production subtracted 0.34 percentage point from second-quarter economic growth, the government said.

``The headwinds we faced at the beginning of 2006 have only become stronger'' Ford Motor Co. Chief Executive Officer Bill Ford said July 13 in a statement.

Companies added to stockpiles at a $52.6 billion annual rate last quarter after adding to inventories at a $41.2 billion pace in the first three months of the year. Inventories added 0.4 percentage point to GDP.

Slowing consumer demand in the U.S. and strengthening exports led to an improvement in the trade deficit. The gap narrowed to $627.1 billion from $636.6 billion in the first quarter. The narrowing added 0.33 percentage point to GDP, the first time in a year that trade has contributed to growth.

PPG Industries Inc., the world's second-largest maker of auto paint, said second-quarter profit jumped 21 percent to a record on higher prices and demand for coatings in Asia and Europe.

`Growth Is Moderating'

``Although growth is moderating to more sustainable levels in North America, we see continued economic expansion worldwide,'' PPG Chief Executive Officer Charles H. Bunch said in the statement. The company is based in Pittsburgh.

The U.S. economy has been accelerating since November 2001, making the 56-month period of expansion under President George W. Bush the fourth-longest of the 10 since World War II ended. The average length of post-war growth periods is 52 months, according to the National Bureau of Economic Research, the Cambridge, Massachusetts-based group that charts the business cycle.

``Obviously, you're not going to have as rapid growth at this point in an economic expansion,'' but ``we feel very good about where we are,'' Al Hubbard, director of the White House's National Economic Council, said in an interview yesterday.

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

Last Updated: July 28, 2006 15:43 EDT