Economy shifted into reverse in late 2012

WASHINGTON -- The U.S. economy shrank unexpectedly late last year, a reminder of the biggest threat it faces in 2013: sharp government spending cuts and prolonged political budget fights.

A plunge in defense spending helped push the economy into negative territory for the first time since mid-2009. The contraction in the October-December quarter came in at an annual rate of 0.1 percent, according to a government estimate released Wednesday.

The likelihood of another recession appears remote. The economy is forecast to grow around 2 percent this year as strength in areas like housing and auto sales could partly offset government cutbacks. Investors appear unfazed, too: The stock market has surged more than 6 percent this year and is nearing an all-time high.

But economists warn that further spending cuts would weaken a still-precarious recovery.

"One way or the other, government is going to be a constraint on growth," said James Marple, senior economist at TD Bank.

Deep spending cuts in defense and domestic programs are set to kick in March 1. Most of the federal government could shut down March 27 if Congress doesn't extend a temporary measure authorizing funding. And the nation's borrowing limit must be raised by May 18 or the government could default on its debts.

A sputtering economy could weaken President Barack Obama's hand in dealing with Congress and complicate his efforts to push forward on other domestic priorities, such as immigration reform and gun control.

The Commerce Department said the economy shrank last quarter mainly because companies restocked at a slower rate and the government slashed defense spending. Exports also fell.

Economists say some of those factors could prove temporary. Still, the slowdown from the 3.1 percent annual growth rate in the July-September quarter was unexpectedly sharp.

For all of 2012, the economy expanded 2.2 percent, better than 2011's growth of 1.8 percent.

The Federal Reserve referred to the fourth-quarter slowdown Wednesday in a statement after a policy meeting. The U.S. economy appears to have "paused in recent months," the Fed said, mainly because of temporary factors. The central bank said growth likely would resume this year. But it reaffirmed its commitment to stimulating the economy by keeping borrowing costs low for the foreseeable future.

Looming government cutbacks might have hindered the economy: Concern about the year-end fiscal cliff could be one reason businesses slowed restocking. And defense spending might have fallen as agencies prepared for automatic spending cuts. Congress managed to avert the fiscal cliff but only postponed the start of automatic spending cuts until March 1.

The drag from the government comes as private-sector growth is picking up. Consumers and businesses spent more in the October-December quarter compared with the July-September quarter.

Consumer spending, which drives about 70 percent of the economy, added 1.5 percentage points to growth last quarter. Business investment and home construction contributed, too.

But government spending cuts and slower company restocking, which can fluctuate sharply, subtracted a combined 2.6 percentage points from gross domestic product. And a drop in exports subtracted an additional quarter-point.

Defense spending plummeted more than 22 percent, the steepest drop in more than 40 years. Nearly all cuts were in services, such as weapons maintenance and personnel support. The Defense Department said spending fell in part because of the drawdown in forces from Iraq and Afghanistan.

The deal Congress reached with the White House to avoid the fiscal cliff delayed spending cuts of about $85 billion. Yet those cuts appear likely to take place eventually. Congressional Republicans see them as a way to force Democrats to make budget concessions.

Americans are coming to grips with an increase in Social Security taxes that is leaving them with less take-home pay. The lower pay could cut roughly a half-point off growth this year, economists said. The automatic spending cuts, if they take place, could subtract an additional 0.3 of a percentage point, Marple estimated.

Everything from the National Park Service to federal law enforcement to health research would be affected. Social Security and veterans' benefits, along with other entitlement programs, would be exempt.

Federal employees would face temporary layoffs, likely causing contracts to be delayed or canceled. Medicare providers -- doctors and hospitals -- would have to absorb cuts in payments. Job losses at some hospitals could follow.

If the two parties don't agree on an extension of government funding by March 27, a shutdown could follow. Each week of a shutdown would slice a quarter-point from growth, Marple said.

Weaker growth could discourage companies from hiring, potentially raising the unemployment rate. The rate has been 7.8 percent for two months. On Friday, the government will release the January jobs report.

Some trends, however, will offset the drag from reduced government spending. Exports, which dropped in the last quarter by the most in nearly four years, should rebound. China's economy is picking up after a brief slowdown and could help spur U.S. exports.

And homebuilders are stepping up construction to meet rising demand, which should create more construction jobs.

Home prices are rising steadily. That tends to make Americans feel wealthier and more likely to spend. Housing could add as much as 1 percentage point to economic growth this year.

Auto sales reached their highest level in five years in 2012. That's boosting production and hiring at U.S. automakers and their suppliers.

The approach of the fiscal cliff last year had one benefit: Incomes jumped in the fourth quarter as companies paid nearly $40 billion in special dividends and bonuses before expected tax increases.

After-tax income, adjusted for inflation, rose 6.8 percent, the most in nearly four years. But incomes may fall in the current quarter because of the end of the Social Security tax cut.

Superstorm Sandy probably dragged growth by closing factories, disrupting shipping and shutting down retail stores. While the department did not specify Sandy's effect on GDP, it estimated that Sandy destroyed about $36 billion in private property and $8.6 billion in government property.

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Associated Press writers Andrew Taylor and Robert Burns contributed to this report.

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