The troubled U.S. economy posted its biggest drop in seven years, according to a government report Tuesday.

The gross domestic product, the broadest measure of the nation’s economic activity, declined 0.5% in the three months ending Sept. 30, according to the Commerce Department.

This was in line with estimates from economists surveyed.

The original reading showed a 0.3% decline.

The third quarter drop was the biggest for the economy since a 1.4% decline in the third quarter of 2001, the last full quarter that the U.S. economy was judged to be in a recession.

While there has yet to be an official determination that the economy is currently in a recession, most economists believe the U.S. is already in one and that the economy is likely to continue to shrink in the fourth quarter and the beginning of 2009.

The economy took a huge hit from a pullback in consumer spending in the quarter. Spending by individuals, rather than businesses or governments, accounts for about 70% of the nation’s economic activity and remained strong enough in the most recent recession of 2001 to allow that downturn to be relatively mild.

But in the third quarter spending by consumers plunged by nearly $80 billion, or 3.7%, the biggest percentage drop in 28 years. And early readings on spending in October suggest that spending and the economy as a whole will be even weaker in the fourth quarter, hit by tight credit, rising job losses and low levels of consumer confidence.

“Everyone is waiting for the hammer blow that weak auto sales is delivering to fourth-quarter growth,” said Robert Brusca of FAO Economics.

But it wasn’t just weak consumer spending dragging the economy down in the third quarter. Business equipment spending tumbled 5.7% while investment in housing slumped 17.6%.

Just ahead of the report, the Treasury Department and Federal Reserve announced a new $200 billion program to make more money available for consumer loans, such as credit cards, auto loans and student borrowing.

It also announced an additional $600 billion that the Fed would spend buying mortgage-backed securities in an effort to lower mortgage rates and support home purchases and prices.

Comments by Federal Reserve Chairman Ben Bernanke that persistent problems in the financial markets threaten the nation’s economy did little to change the dollar’s upward move.

The 15-nation euro traded at $1.48, down from $1.49 late Thursday. The greenback bought ¥110.08, up from ¥108.44.

Global economies slow: The dollar was sharply higher versus the pound after the United Kingdom’s 2nd-quarter gross domestic product was revised to no growth, below economists’ forecast of a 0.2% increase, according to Tom Benfer, director of foreign exchange at Bank of Montreal.

The pound was trading at $1.8526 Friday, sharply below $1.8778 late Thursday. When “one currency moves that far, the other currencies follow to an extent,” said Benfer.

This follows reports showing economic declines in the quarter in both Japan and the euro zone, said Vassili Serebriakov, currency strategist at Wells Fargo.

“We have seen strong evidence that economic growth is slowing globally,” he said.

As other economies struggle, the dollar has had an opportunity to climb. “A number of economies are slowing sharply – that has helped the U.S. dollar over the past couple weeks,” said Serebriakov.

The dollar has been trending higher for the past 2 weeks. “The events of the previous 2 weeks strongly suggest that we have seen the cyclical bottom in the U.S. dollar,” said Serebriakov.

Bernanke: The Fed Chairman spoke about the economy at an annual Jackson Hole, Wyo., symposium sponsored by the Kansas City Federal Reserve.

“Although we have seen improved functioning in some markets, the financial storm that reached gale force some weeks before our last meeting here in Jackson Hole [last August] has not yet subsided,” Bernanke said. “Its effects on the broader economy are becoming apparent in the form of softening economic activity and rising unemployment.”

“The initial reaction as far as the dollar is concerned is muted,” according to Benfer. The stock market firmed after the speech, however, and he said that is “generally supportive of the dollar.”

“He did indicate that the Fed is watching developments very, very closely – they are not taking their eye off the ball,” said Benfer.

“The markets are looking for a blueprint, a battle plan, a sense of direction,” said Benfer. “If the markets get some sense that the central bank, the Treasury have their arms around this – even if it takes a long time – that will be a positive.”

Dollar and oil: Oil prices tumbled by the 2nd-largest 1-day drop ever, in dollar terms, on the back of the stronger dollar. Crude futures closed $6.59 per barrel lower to settle at $114.59 on the New York Mercantile Exchange.

The drop in the price of oil was the biggest single-day fall in dollar terms since Jan. 17, 1991, when oil fell by $10.56.

On Thursday, the dollar lost ground on fresh concerns about the financial sector. As the dollar weakened, investors moved their funds into the commodity market, helping oil prices jump more than $6 a barrel.

“The key short-term driver [for the dollar] has really been the oil price,” said Serebriakov.

High oil prices hurt U.S. companies and consumers, affecting economic growth.

“Higher oil prices have significant effect on the U.S. growth – that is the primary reason why oil is bad for the dollar,” said Serebriakov.

In addition, a weaker dollar makes oil cheaper to foreign investors, because crude oil is traded in U.S. currency globally. In addition, when investors watch the dollar fall, commodities appear to be a safe haven for their assets.

“The oil and the dollar have moved together, but it is not a simple answer as to what is driving what,” said Serebriakov. “They go hand in hard, and it is the chicken-and-the-egg problem.”

First Published: August 22, 2008: 9:39 AM EDT

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