This was the second monthly report that defied expectations that the economy had grown. Slumping manufacturing, wholesale trade and oil and gas activity weighed down output in the month.

The weakness in August was concentrated in the goods-producing sectors where output contracted by 0.7 percent. The weakness was widespread with agriculture, mining/oil and gas extraction, and manufacturing reducing output. Construction and utilities production rose in the month. In the manufacturing sector, output fell 0.7 percent despite a rise in auto manufacturing as labour disputes reduced output in the primary metals output sub sector. In the broader industry, mining output fell by 1.4 percent on the back of temporary closures. Oil and gas extraction activity also fell as maintenance work on facilities cut production.

Wholesalers also saw output fall in August, by 0.5 percent. Limiting the impact of this decline was a pick-up in retail trade, which rose 0.3 percent. Overall, service-producing industries' output rose by 0.1 percent helped along by a 0.6 percent rise in public administration.

"August marked the second month of limited economic activity," said Dawn Desjardins, assistant chief economist for RBC Economics Research. "This charts a course for the economy to have stopped contracting in the third quarter but falls short of forecasts for a 2 percent annualized gain. While the monthly GDP figures track a flat reading in the third quarter, our reckoning is that, on an expenditure basis, real GDP growth will be between one half and one percentage point at an annualized rate."

Looking forward, Desjardins said the rebound in U.S. economic growth, low interest rates combined with government spending augur well for an improving trend to emerge in the quarterly growth rates. In its Monetary Policy Report last week, the Bank of Canada cited a list of "favourable developments" for Canada's economy, although it cautioned that “the current strength in the dollar is expected, over time, to more than fully offset the favourable development since July.”

"Today's report will keep the Bank of Canada cautious about the outlook as the August data generated downside risks to the Bank's forecast that the economy grew at a 2 percent annualized pace in the third quarter," she said. "Given the soft start to Canada's economic recovery, we expect the Bank to hold the policy rate at 0.25 percent until the second half of 2010."

U.S. personal consumer spending declines as impact of car rebates fades

Personal consumer expenditure (PCE) fell an expected 0.5 percent in September following a 1.4 percent rise in August. With personal income unchanged in the month, the savings rate rose to 3.3 percent from 2.8 percent in August.

The decline in PCE largely reflected the ending of the auto rebate program, which sent consumer spending on durables down 7 percent in the month, after a 6.1 percent jump in August. This weakness in September was tempered by increases of 0.7 percent and 0.2 percent for non-durables and services, respectively. The impact of price changes was relatively limited with the volume of consumer spending down only an additional 0.1 percentage point to -0.6 percent. This reflected the volume of durables falling 7.2 percent tempered by gains of 0.5 percent and 0.1 percent in the non-durables and services components, respectively.

The core PCE deflator was up only 0.1 percent in the month compared to an expected gain of 0.2 percent. This left the year-over-year rate unchanged at the August rate of 1.3 percent.

"Today’s report provides the monthly detail behind the 3.4 percent annualized gain in consumer spending contained in yesterday’s third-quarter advance GDP report," said Paul Ferley, assistant chief economist with RBC Economics Research. "The sizeable decline in the volume of consumer spending in September reflected the end of auto rebates. It also implies a weak handoff going into the fourth quarter that raises concerns that the rebate program largely advanced sales activity.

"Our current forecast assumes flat fourth-consumer spending with activity rising by a minimal 0.5 percent. Expectations for this key expenditure area will be refined further next Tuesday with the release of the October unit motor vehicle sales," he said. "Our expectation is for a modest improvement to 9.5 million units, up from 9.2 million in September but down sharply from the recent peak recorded in August of 14.1 million."

Ferley predicted the uncertainty about the sustainability of growth in consumer spending may result in the Fed keeping monetary conditions accommodative in the near-term. RBC's forecast assumes that a sluggish rebound in activity and the persistence of high unemployment will delay any hike in Fed funds until the end of 2010.