* Third-quarter growth at 2 percent annual rate
* Consumer spending accounts for bulk of gain
* Gov't defense spending jumps, inventories drag
* Housing supportive; business spending and trade drags
* Growth pace still too sluggish to lower unemployment
WASHINGTON, Oct 26 (Reuters) - U.S. economic growth accelerated in the third quarter a s stepped-up purchases by consumers an d a surprise turnaround in government sp ending of f set the first cutback in business investment in more than a year.
The stronger pace of expansion, however, fell short of what is needed to make much of a dent in unemployment, and offers little cheer for the White House ahead of the closely contested Nov. 6 presidential election.
Gross domestic product expanded at a 2 percent annual rate, the Commerce Department said on Friday in i ts f irst estimate of the third quarter, a pick up f r om the second quarter's 1.3 percent pace. A pace in excess of 2.5 percent is needed over several quarters to make substantial headway cutting the jobless rate.
The report was a bit better than economists had expected, in part because of a surge in government defense spending that was not expected to last. De fense spending rose at its fa stest pace in thr ee years, c ombining with the ris e in hou sehold co nsumption an d a jump in home building to strengthen domestic demand.
``The economy still has only weak forward momentum. Some underlying fundamentals are improving, but uncertainty at home and abroad is holding back the business sector,'' said Nigel Gault, chief U.S. economist at IHS Global Insight in Lexington Massachusetts.
Stocks on Wall Street were flat in early afternoon trade, while prices for U.S. Treasury debt rose. The dollar was little changed against a basket of currencies.
Since climbing out of the 2007-09 recession, the economy has faced a series of headwinds from high gasoline prices to the debt turmoil in Europe and, lately, fears of U.S. government austerity. It has struggled to exceed a 2 percent growth pace and remains about 4.5 million jobs short of where it stood when the downturn started.
White House adviser Alan Krueger said the report underscored t he need to extend tax cuts for the middle class and small businesses, as President Barack Ob ama h as proposed. O b ama's Republican challenger, Mitt Rom ney, d e scribed it as evidence of the president's f ailed policies.
In the third quarter, consumers shrugged off the impending sharp cuts in government spending and higher taxes that are due next year and went on a bit of a shopping spree, with spending strong for automobiles and Apple Inc's iPhone 5.
Consumer spending, which accounts for about 70 percent of U.S. economic activity, grew at a 2 percent rate after increasing 1.5 percent in the prior period.
A second report showed consumer sentiment reached its highest point in five years, another sign households are little worried by the so-called fiscal cliff that is set to drain about $600 billion from the economy in 2013 unless Congress acts.
SPENDING DESPITE INCOME SQUEEZE
High stock prices and firming home values have made households a bit more willing to take on new debt, supporting consumer spending even in the face of higher gasoline prices.
An inflation gauge in the GDP report rose at a 1.8 percent rate, accelerating from the second quarter's 0.7 percent pace. But a core measure that strips out food and energy costs slowed to a 1.3 percent rate, suggesting the rise in overall inflation will be temporary.
Even so, with about 23 million Americans either out of work or underemployed, consumers might have to cut back, especially if they get a higher tax bill in 2013.
Incomes were squeezed in the last quarter -- rising just 0.8 percent after accounting for inflation and taxes -- and households cut back on saving to ramp up spending.
Government spending, which snapped eight straight quarters of declines, accounted for 0.7 percentage point of GDP growth. Defense outlays jumped at a 13 percent annual rate, the most since the second quarter of 2009, after dropping for three straight quarters.
Todd Harrison, an analyst with the Center for Strategic and Budgetary Assessments, said the spike was likely linked to the fact that there were three military pay dates in August, instead of the typical two.
Fears of the fiscal cliff hammered business spending, which dropped at a 1.3 percent pace, the first decrease since the first quarter of 2011.
``We are being really cautious about (the) kinds of investments we make and the kinds of risks we are taking in this environment,'' Newell Rubbermaid Inc chief executive Mike Polk told Reuters on Friday.
Worries over slower global growth have also weighed on the corporate sector, which has issued a series of disappointing third-q u arter earnings reports. Ac cording to Thomson Reuters data, 63 percent of companies ha v e posted revenues below analysts' expectations; se veral have also announced job cuts.
Slowing global demand, particularly weakness in Europe and China, caused U.S. exports to contract for the first time since the first quarter of 2009. Ev en though imports fell for the first time in three years, tra de weighed on GDP growth.
Inventories were a drag on growth because of a drought in the country's Midwest, which has decimated crops. Farm inventories cut 0.42 percentage point from GDP growth and could remain a drag in the fourth quarter.
However, home building surged at a 14.4 percent rate, thanks in large part to the Federal Reserve's ultra accommodative monetary policy stance, which has driven mortgage rates to record lows.
Economists say housing - the epicenter of the last recession - will contribute to growth this year for the first time since 2005.