Oil price and dollar plunge as American growth stalls

Oil prices plunged and the dollar fell sharply last night amid fears that the US economy is buckling under the weight of rising interest rates and the threefold increase in oil prices.

Wall Street was urging the Federal Reserve to hold back from an expected rise in interest rates next month after the commerce department in Washington reported that the growth rate in the world's biggest economy more than halved in the second quarter of 2006.

Evidence of a marked slowdown in the housing market - the mainstay of the economy in recent years - and an end to the government spending spree to rebuild the southern states devastated by Hurricane Katrina meant the economy was expanding at an annual rate of 2.5% in the three months to June. In the first quarter, growth was an annualised 5.6%.

Growth in the first three months of the year was inflated by the billions spent by Washington on repairing the damage caused by the hurricane that left New Orleans under water last August, but non- military federal spending fell at an annual rate of 8% in the second quarter, wiping out the first quarter's gain.

With analysts expecting a further weakening of the economy, share prices were boosted last night by anticipation that the Fed would call an end to the ratcheting up of interest rates that has seen borrowing costs rise from 1% to 5.25% in 17 quarter-point jumps. By lunchtime in New York, the Dow Jones average was up more than 130 points at 11,232 points on the hope that the Fed would reassure consumers next month that interest rates had now peaked at 5.25%. However, many analysts believe the Fed will raise rates again next month in order to be sure of tackling rising core inflation, which rose from 2% to 2.9% in the second quarter.

Rob Carnell, of ING Financial Markets, said: "Inflation is still running above levels the Fed will be comfortable with, so although this release adds further weight to calls for a Fed pause in August, there is still a risk management argument for one final rate hike, though this is looking harder to justify."

A protracted period of low interest rates made borrowing cheap for Americans and prompted a property and consumer boom, but yesterday's figures suggested that US citizens have started to tighten their belts in response to dearer borrowing and rising energy costs. Consumption growth slowed from an annualised 4.8% in the first quarter to 2.5% in the second quarter. Spending on consumer durables was slower in the second quarter as the housing market stalled and the cost of heating a home and running a car rose. Investment in residential property fell by 6%, while capital investment was also much weaker than the markets had been predicting.

Concern that the US economy would slow down still further prompted a $1.50 drop in the price of oil, which was trading at just over $73 a barrel in New York at around lunchtime yesterday. On the foreign exchanges, the dollar lost around 1% of its value against the Japanese yen and was down 0.5% against the euro at $1.2765.

"Growth was sharply lower than expected and we've got a knee-jerk reaction down in the dollar," said Korman Tam, chief forex analyst at MG Financial. "It confirms suspicions and raises expectations that the Fed will actually pause in August."

In the New York futures markets, the chances of an increase in interest rates dropped as low as 24%, having stood at 46% before the downbeat report from the commerce department. "This report makes a compelling case for no further rate hikes," said Chris Low, chief economist with FTN Financial in New York.