U.S. economic expansion slowed abruptly in the second quarter to less than half the pace at the start of the year, while a key inflation gauge shot up at the fastest rate since 1994, the government said on Friday.

The Commerce Department said the sharp slowdown was caused mainly by softer consumer spending. The data raised expectations in financial markets the Federal Reserve was near a halt in its two-year-old campaign of interest-rate rises.

Stock and bond prices gained strongly on the news, taking it as a hopeful indicator that interest rate levels will soon level off and that the world's largest economy would be able to keep growing at a slower but sustainable rate.

Gross domestic product grew at a 2.5 percent annual rate in the April-June quarter, well below Wall Street analysts' forecasts for 3 percent and less than half the robust 5.6 percent rate registered in the first quarter.

GDP measures all goods and services produced within U.S. borders and was running at an $11.4-trillion rate in the second quarter, after adjustments for inflation.

Not only was there a decrease in consumer spending on costly durables like cars, but export growth slowed, government spending was weaker and housing investment turned down.

At the same time, an inflation gauge favored by the Federal Reserve, a measure of personal consumption expenditure prices minus food and energy, jumped at a 2.9 percent rate in the second quarter, well ahead of the first quarter's 2.1 percent.

PRICES ON THE RISE

It was the fastest rate of increase for the gauge of so-called core inflation in nearly a dozen years, since the third quarter of 1994 when it jumped at a 3.2 percent rate.

Foreign exchange analyst Korman Tam of MG Financial in New York similarly said the GDP report appeared to buttress signs of a broad-based slowdown reported earlier in the Fed's anecdotal Beige Book survey of national economic conditions.

It confirms suspicions and raises expectations that the Fed will actually pause in August, Tam said.

Another report on Friday showed consumers remained hopeful about their prospects. The University of Michigan's final reading on consumer sentiment rose to 84.7 in July from an initial reading of 83.0, only modestly lower than June's 84.9 reading.

By mid-afternoon, the Dow Jones industrial average was ahead more than 130 points and the high tech-laden Nasdaq composite index was up more than 30. Prices for debt securities were higher across the range of maturities from two-year notes to 30-year bonds.

Separately, the Labor Department reported its Employment Cost Index, which covers wages, salaries and benefits, climbed by a bigger-than-expected 0.9 percent in the second quarter. That was the largest increase since the first quarter of 2005, a potential warning sign on inflation.

Economist Joel Naroff of Naroff Economic Advisors Inc. in Holland, Pa., said rising wage costs were likely to raise a red flag for Fed policy-makers since they were broad-based and had gained steam in the spring quarter.

Naroff predicted the Fed will add inflation insurance through another rate rise on August 8, on top of the 17 the Fed has initiated already since mid-2004.

PAIN AT THE PUMPS

The economy had been widely expected to slow after a sizzling first quarter, in part because a cooling housing market coupled with soaring gasoline prices is expected to act as a brake on consumer spending.

Fed Chairman Ben Bernanke told Congress last week he expected softer growth to restrain inflation over time, though it was not apparent in Friday's second-quarter GDP data.

The GDP report included annual revisions that covered the period from the beginning of 2003 through 2005. They showed moderately slower growth than first estimated, with the economy growing at an average annual rate of 3.2 percent over the period, 0.3 percentage point less than previously reported.

Consumer spending, which fuels about two-thirds of national economic activity, increased at a 2.5 percent annual rate in the second quarter, sharply below the first quarter's 4.8 percent. Business investment slowed to a 2.7 percent rate of increase, a fraction of the first quarter's 13.7 percent and the slowest since a 1.7 percent rate of growth in the first quarter of 2004.

Business spending on new computers and software, after soaring at a 15.6 percent rate in the first quarter, shrank 1 percent in the second quarter, the first fall in this category of spending since the start of 2003.

Underlining the growing softness in housing, investment in residential construction shrank for a third successive quarter, declining at a 6.3 percent rate.

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