The U.S. economy expanded at a 3.2 percent annual rate in the first quarter as consumers stepped up spending, the strongest sign yet a sustainable recovery is taking hold.

While growth slowed from the fourth quarter's rapid 5.6 percent pace and was a touch weaker than economists expected, the details of the report from the Commerce Department on Friday were fairly upbeat.

Consumer spending, which normally accounts for about 70 percent of U.S. economic activity, added nearly 2.6 percentage points to U.S. gross domestic product last quarter, the biggest contribution since the fourth quarter of 2006.

Once you take a quick look under the hood you see some very positive signs there, said Ward McCarthy, chief financial economist at Jefferies & Co. in New York. This is just the latest piece of evidence to suggest that the recovery is sustainable.

Still, markets showed some disappointment. U.S. stock markets were lower, while prices for U.S. government debt edged up. The dollar was little changed.

Analysts had expected GDP, which measures total goods and services output within U.S. borders, to grow at a 3.4 percent rate in the first three months of 2010.

The economy has now grown for three straight quarters, although it still has a lot of lost ground to make up after its deepest and longest recession since the 1930s.

The report showed consumer spending rose at a 3.6 percent rate in the January-March period, more than double the 1.6 percent pace in the fourth quarter and the biggest gain since the first quarter of 2007.

Retail sales are up, people are spending money, said Michael Woolfolk, senior currency strategist at BNY Mellon in New York. We're seeing the beginning of the process of a broad-based recovery.

The United States has emerged from recession more swiftly than Europe or Japan. Euro zone first-quarter GDP data is due in mid-May and is expected to show annualized growth of roughly 0.8 percent. Japan, which has been struggling with deflation, does not report its data until later in May.

Analysts said the welcome but moderate pace of U.S. growth meant the Federal Reserve could bide its time before raising benchmark interest rates from their current levels near zero, particularly with unemployment hovering near 10 percent.

The U.S. central bank on Wednesday noted activity had strengthened in recent weeks and that the labor market was starting to improve. Still, it said it expects a modest recovery and renewed its vow to keep rates low for an extended period.

BUSINESSES RESTOCK SHELVES

Business inventories increased $31.1 billion in the first quarter, adding 1.57 percentage points to GDP, as businesses restocked to meet firming demand. It was the first increase in inventories since the first quarter of 2008.

Businesses also continued to spend on software and equipment, though a bit less vigorously than in the prior quarter, boding well for the economic recovery.

If they are spending on equipment already, it shows a lot of confidence for the future hiring which supports consumer spending. If we continue to have employment growth, we will have a good year, said Kurt Karl, head of economic research at Swiss Re in New York.

Last month the economy enjoyed the strongest jobs growth in three years as private employers stepped up hiring.

New home construction was a drag on growth in the first quarter after two quarters of gains. Residential investment contracted at a 10.9 percent rate.

Business spending on structures subtracted from GDP for a sixth straight quarter.

Export growth slowed sharply to a 5.8 percent pace in the first quarter from a 22.8 percent rate in the prior period, while imports rose at an 8.9 percent rate. That left a trade deficit that chipped off 0.61 percentage point from GDP.

A separate report from the U.S. Labor Department showed employment costs rose 0.6 percent in the first quarter as benefit costs posted their biggest gain since the second quarter of 2002. Wages advanced just 0.4 percent.

Other reports showed business activity in both New York city and Chicago grew in April, providing additional signs the economy's recovery was growing more durable.

The Thomson Reuters/University of Michigan's Surveys of Consumers showed sentiment falling in April from March as consumers saw the recovery as well under way, but slow. However, their view on how the economy will look 12 months from now improved from the prior month.

(Additional reporting by Chris Reese in New York; Editing by Andrea Ricci)

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