* Economy grows at 2 pct annual rate in 3rd quarter
* Consumer spending accounts for bulk of gain
* Government defense spending jumps; inventories drag
* Growth still too weak to substantially cut unemployment
WASHINGTON, Oct 26 (Reuters) - U.S. economic growth accelerated in the third quarter as a last minute spurt in consumer spending and a surprise turnaround in government outlays offset the first cutback in business investment in more than a year.
Even so, the stronger pace of expansion fell short of what is needed to make much of a dent in unemployment, and it offered little cheer for the White House ahead of the closely contested Nov. 6 presidential election.
Gross domestic product grew at a 2 percent annual rate, the Commerce Department said on Friday in its first estimate of the third quarter, a pick-up from the second quarter's 1.3 percent pace. But to make substantial headway cutting the jobless rate, the economy needs to grow by more than a 2.5 percent pace over several quarters.
The growth was a bit better than economists had expected, in part because of a surge in government defense spending, which was not expected to last. Defense spending rose at its fastest pace in three years, and combined with the rise in household consumption and a jump in home building to strengthen domestic demand.
``The economy still has only weak forward momentum,'' said Nigel Gault, chief U.S. economist at IHS Global Insight in Lexington Massachusetts. ``Some underlying fundamentals are improving, but uncertainty at home and abroad is holding back the business sector.''
U.S. stocks ended the day little changed, with corporate earnings holding greater sway over market sentiment, while Treasury debt prices rose. The dollar was flat against a basket of currencies.
Since climbing out of recession, the U.S. economy has faced a series of headwinds ranging from high gasoline prices to the debt turmoil in Europe and, lately, fears of U.S. government austerity. The economy 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 GDP report underscored the need to extend tax cuts for the middle class and small businesses, as President Barack Obama has proposed. Obama's Republican challenger, Mitt Romney, described it as evidence of the president's failed policies.
In the third quarter, consumers shrugged off the impending sharp cuts in government spending and higher taxes that are due early next year and went on a bit of a shopping spree, buying automobiles and snapping up 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 second quarter.
A separate private-sector report showed consumer sentiment rose this month to its highest point in five years, another sign households are little worried by the looming fiscal cliff at year end that will raise income taxes and is estimated to drain about $600 billion from the economy next year 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 government's GDP report rose at a 1.8 percent rate, up 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 slapped with a higher tax bill in 2013.
Incomes were squeezed in the third quarter -- rising just 0.8 percent after accounting for inflation and taxes -- and households slowed their saving to ramp up their 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 consecutive quarters. The surge was mainly in defense services -- installation, and support for both weapons and personnel.
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,'' the chief executive of consumer products maker Newell Rubbermaid Inc, Mike Polk, told Reuters on Friday.
Worries over slower global growth have weighed on the corporate sector, which has issued a series of disappointing third-quarter earnings reports. According to Thomson Reuters data, 63 percent of companies have posted revenues below analysts' expectations; several 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. Exports declined by 1.6 percent, outstripping a 0.2 percent decline in imports, marking the first drop in imports for three years.
Another spot of weakness in the GDP report were inventories, which were squeezed by a drought in the U.S. Midwest. Farm inventories cut 0.42 percentage point from GDP growth and could remain a drag in the fourth quarter.
Home building, which has been a weak spot in the economic recovery, 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.