The U.S. gross domestic product came in short of the economists' forecast of 1.1 percent growth.
The department said third quarter growth reached 3.1 percent, revising a figure that started at 2 percent when it was at the advanced estimate stage three months ago.
Stock markets have been on a four-week winning streak with the Dow Jones industrial average reaching a 63-month high Tuesday. The dour GDP report and a recent drop in the consumer confidence index is likely to hold the stock rally in check.
The contraction, when considered along with the difficult budget negotiations in Washington, could also impact the U.S. credit rating, which affects borrowing costs negatively, setting up a deeper contraction, said University of Maryland economics professor Peter Morici.
The Commerce Department said the GDP dropped with a pull back in exports and a $40 billion contraction in business inventories.
Consumer spending adjusted for inflation rose 2.2 percent in the fourth quarter after rising 1.6 percent in the third. In another positive development, commercial fixed investment expenditures rose 8.9 percent after shrinking 1.8 percent in the previous quarter.
Exports, however, fell 5.7 percent in the quarter and imports shrank 3.2 percent, a net negative on the GDP.
Federal spending fell sharply, off 15 percent in the quarter, the bulk of that national defense spending, which was off 22.2 percent. Separately, non-defense spending rose 1.4 percent October through December.
Commerce said personal income rose sharply, up 7.9 percent, pushed by "a sharp acceleration in personal dividend income," which was brought on, partly, by companies anticipating changes in the individual income tax rates.