Economists said the drop in gross domestic product wasn't as bleak as it looked. The weakness was mainly the result of one-time factors. Government spending cuts and slower inventory growth, which can be volatile, subtracted a combined 2.6 percentage points from GDP.
But the fact that the economy shrank at all, combined with much lower consumer confidence reported Tuesday, could raise fears about the economy's durability in 2013. That's because deep government spending cuts will automatically slash domestic and defense programs starting in March unless Congress reaches a deal to avert them.
And Americans are coming to grips with an increase in Social Security taxes that has begun to leave them with less take-home pay.
The government spending cuts and slack inventory growth in the fourth quarter offset a 2.2 percent increase in consumer spending. And business spending on equipment and software rose after shrinking over the summer.
Consumer spending added 1.5 percentage points to GDP, and business investment added 1.1 points — both stronger contributions than in the third quarter.
"Frankly, this is the best-looking contraction in U.S. GDP you'll ever see," Paul Ashworth, an economist at Capital Economics, said in a research note. "The drag from defense spending and inventories is a one-off. The rest of the report is all encouraging."
For all of 2012, the economy expanded 2.2 percent, better than 2011's growth of 1.8 percent.
The plunge in defense spending in the October-December quarter followed a jump in the third quarter. The fluctuation might have reflected higher-than-usual spending that occurred in the July-September period in anticipation of government spending cuts later in the year. Some defense contractors reported lower government spending at the end of the year.
Last week, General Dynamics blamed a $2 billion loss in the fourth quarter on "slowed defense spending."
Exports fell by the most in nearly four years, a result of Europe's recession and slower growth in China and some other large developing countries.
Incomes, though, jumped last quarter as companies paid out special dividends and bonuses ahead of expected tax increases in 2013. Commerce estimated that businesses paid nearly $40 billion in early dividends. After-tax income, adjusted for inflation, rose 6.8 percent, the most in nearly four years.
Superstorm Sandy likely also dragged on 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.
Subpar economy growth has held back hiring. The economy has added about 150,000 jobs a month, on average, for the past two years. That's barely enough to reduce the unemployment rate, which has been a still-high 7.8 percent for two months.
Economists forecast that unemployment stayed at that rate in January. The government will release the January jobs report Friday.
The slower growth in stockpiles followed a jump in the third quarter. Slower inventory growth means factories likely produced less. Heavy equipment maker Caterpillar Inc. said this week, for example, that it reduced its inventories in the fourth quarter as global sales declined from a year earlier.
Still, with consumer spending rising, companies might have to rebuild inventories in the current January-March quarter, economists say. That could boost growth.
Wednesday's report is the first of three estimates of GDP the government issues each quarter. GDP measures the nation's total output of goods and services — from restaurant meals and haircuts to airplanes and appliances. The estimates of GDP are revised by an average of 1.3 percentage points between the first and third estimate. That means the final figure for the fourth quarter might end up showing either growth or a steeper contraction.
A big question for 2013 is how consumers will react to the expiration of the Social Security tax cut. Congress and the White House allowed the temporary tax cut to expire in January but prevented income taxes from rising for most Americans.
The Social Security tax increase will reduce take-home pay this year by about 2 percent. A household earning $50,000 a year will have about $1,000 less to spend. A household with two high-paid workers will have up to $4,500 less.
A key measure of consumer confidence plummeted this month after Americans noticed the reduction in their paychecks, the Conference Board reported Tuesday.
Several trends, though, are expected to boost growth later this year.
Home builders are stepping up construction to meet rising demand. That should create more construction jobs.
And 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.
In addition, auto sales reached their highest level in five years in 2012. That's boosting production and hiring at U.S. automakers and their suppliers.