The U.S. economy grew at a weaker-than-expected 3.1 percent annual pace in the final quarter of 2004 year, its slowest since the beginning of 2003 as the country's trade performance deteriorated and inflation picked up, a government report on Friday showed.

The increase in fourth-quarter gross domestic product (search), or GDP, which measures total output within U.S. borders, was down from a 4 percent gain in the third quarter and was the weakest since a 1.9 percent pace in the first quarter of 2003.

It also was below Wall Street economists' forecasts for a 3.5 percent rate of fourth-quarter expansion.

Despite the softer fourth quarter, GDP in 2004 advanced 4.4 percent, up from 3 percent in 2003 and the most robust since 1999. Private-sector economists generally predict continued expansion in 2005 at around 3.5 percent, which is considered to represent the U.S. economy's long-term growth potential.

The Commerce Department (search) report showed exports of goods and services fell at the steepest rate in two years during the October-December quarter while imports rose.

The GDP report sent stock futures lower, since it implied a tougher prospect for profits, and the dollar weakened against the euro initially. Bond prices strengthened.

Inflation showed signs of picking up. A price index favored cited by Federal Reserve (search) Chairman Alan Greenspan -- personal spending minus food and energy costs -- climbed at a 1.6 percent annual rate in the fourth quarter, nearly twice the 0.9 percent advance posted in the third quarter.

The Fed's policy-setting Federal Open Market Committee (search) meets next week and is expected to announce on Wednesday that they are raising interest rates for a sixth time since June by a quarter percentage point.

Separately, the Labor Department reported U.S. employment costs rose at a less-than-expected rate in the fourth quarter.

Its employment cost index rose 0.7 percent in the last three months of 2004, as salaries and wages grew at their slowest rate in nearly six years. Wall Street had forecast the Employment Cost Index (search), a broad gauge of what employers pay in wages and benefits, to rise 0.9 percent between October and December, after a 0.9 percent gain the previous three months.

On balance, analysts said the data implied the U.S. central bank should not feel worried that an imminent leap in inflation was at hand that could force a faster rate of U.S. interest-rate increases.

"This is a plus for the (stock) market overall because growth is above 3 percent -- which is decent -- and employment cost is below expectations, which should encourage the Federal Reserve at next week's meeting to maintain a balanced approach," said Ken Tower, a market strategist with Charles Schwab in Princeton, New Jersey.

The GDP report showed that personal spending -- which fuel about two-thirds of U.S. economic growth -- increased at a 4.6 percent annual rate in the fourth quarter, slowing from the third quarter's 5.1 percent gain.

Inventories grew at a $45.8 billion rate, up from $34.5 billion in the third quarter in a potentially positive sign since it may indicate businesses anticipate better sales and production.

Most other recent data on the economy has implied further expansion, including Thursday's report showing that orders for costly durable goods rose 0.6 percent in December so that the manufacturing sector entered 2005 on a strong footing.

Hiring has not been robust, however, because many businesses are trying to boost production with smaller workforces and service companies are sending many jobs offshore to take advantage of cheap labor costs.

The GDP report painted a bleak picture on trade, showing a steep 6.9 percent drop in the annual rate of goods exports during the fourth quarter, which nearly reversed a 9.5 percent third-quarter increase. Imports of good and services surged at a 9.1 percent rate, which was more than double the 4.6 percent third-quarter rise.

Mounting U.S. trade and budget deficits are causing worry among trading partners. That theme is expected to be heard when Group of Seven finance ministers meet in London on Feb. 4-5, with European and Japanese anxiety already high over the dollar's weakness against their currencies.

Michael Woolfolk, a New York-based currency strategist with Bank of New York, said the GDP numbers were disappointing, and showed a drag from costlier energy that is unlikely to be reversed since imported oil prices remain high by historical standards.

"It shows the economy has returned to the long-term trend growth rate of 3.1 percent, the average over the last several decades, as higher interest rates and higher energy prices" have an impact, Woolfolk said.