* UK economy expands 0.4 pct q/q in third quarter
* Data bolsters case for BoE rate hike
* Services industry drives growth, factories contribute too
* UK Finance figures point to solid lending
(Adds reaction, graphics) LONDON, Oct 25 (Reuters) - Britain's sluggish economy perked up slightly during the past three months, an unexpected boost that clears the way for the Bank of England to raise interest rates next week for the first time in a decade. While falling short of the strong growth rates enjoyed by euro zone countries earlier this year, British economic growth picked up to 0.4 percent in the July-September period from 0.3 percent in the second quarter, official data showed on Wednesday. Sterling climbed almost a full percentage point against the U.S. dollar on the figures, which beat the average forecast for growth of 0.3 percent in a Reuters poll of economists. British five-year government bond yields also rose to their highest since last year's vote to leave the European Union as markets anticipated a quicker pace of BoE rate rises next year. Britain performed much better than most economists expected immediately after last year's vote to leave the European Union, and it was one of the fastest-growing major advanced economies in 2016. But it slipped to the bottom of the pack earlier this year, posting its worst first-half performance since 2012, largely due to higher inflation caused by the pound's fall after the Brexit vote, at a time when its peers have enjoyed robust growth, While Wednesday's figures are a small boost for under-pressure finance minister Philip Hammond ahead of his November budget, they do not alter the broad picture of an economy dogged by poor productivity and squeezed living standards. "Despite the weak outlook, the Bank of England will now almost certainly raise the Bank Rate by 25 basis points ... on 2nd November," said Daniel Vernazza, chief UK economist at UniCredit. A Reuters poll published on Tuesday showed the BoE is widely expected to raise rates to 0.50 percent from 0.25 percent on Nov. 2, due to concerns that the economy cannot grow as fast as it used to without generating excess inflation. Financial markets nudged up the chance of a move to nearly 90 percent from just over 80 percent before the data.
Last month the BoE said Wednesday's preliminary data from the Office for National Statistics (ONS) was likely to show 0.3 percent growth, though it might be stronger due to improving consumer demand. In the past, Britain's economy typically grew by 0.5-0.6 percent a quarter but the BoE and other economists have indicated that the sustainable growth rate may have fallen.
FOCUS ON PRODUCTIVITY Hammond told broadcasters the growth figures were "solid" and proof of the fundamental strength of an economy that since the referendum had often made forecasters look too pessimistic. In a separate statement, he said he was focused on boosting productivity - arguably Britain's biggest economic problem - in order to create more higher-wage jobs. Next month's budget would consider ways to support high-growth firms short of finance, the housing sector and consumers, but the economic situation placed limits on what could be done, Hammond added. Britain's budget watchdog has said it expects to chop its forecasts for productivity growth in coming years, suggesting the economy will have less room to grow without generating inflation - a diagnosis shared by BoE Governor Mark Carney. In the short-term, a further argument in favour of higher rates might come from solid bank lending figures from industry association UK Finance. Nonetheless, most economists polled by Reuters think it would be a mistake for the BoE to hike interest rates now, in part because of the economic uncertainty generated by the Brexit process. The ONS data showed the vast services industry was behind the bulk of Britain's economic expansion in the third quarter, but manufacturing also contributed, helped by a rebound in car production. In year-on-year terms, third-quarter growth was unchanged at 1.5 percent, also slightly stronger than analysts had expected. Britain's dominant services maintained its momentum from the previous quarter, the ONS said, while industrial output expanded at its fastest rate in more than a year. Construction continued to struggle, however, contracting by 0.7 percent on the quarter - its sharpest fall since the third quarter of 2012. "We would urge the (BoE) to proceed with caution on raising rates, as tightening monetary policy amid the current economic and political uncertainty could weaken growth," said Suren Thiru, head of economics at the British Chambers of Commerce. The preliminary estimates of GDP do not include a breakdown of spending, and are heavily based on estimated data.
(Editing by John Stonestreet and Hugh Lawson)