The U.S. economy expanded at a 3.2 percent annual rate in the first quarter as consumers increased spending at the fastest pace in three years, the strongest sign yet a sustainable recovery may be 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 Friday's report from the Commerce Department were fairly upbeat.

President Barack Obama, whose popularity has suffered because of public discontent over the economy, hailed the data as a step in the right direction, but stressed more needed to be done.

Our economy is stronger, that economic heartbeat is growing stronger, Obama said at the White House. While today's GDP report is an important mile post on our road to recovery, it doesn't mean much to an American who has lost his or her job and can't find another.

High unemployment remains a sore point as the economy climbs out of its deepest and longest recession since the 1930s. While the economy has now grown for three straight quarters, widespread joblessness is hurting Obama's approval ratings and dimming his fellow Democrats' prospects for November elections, in which they will fight to keep their majorities in both houses of Congress.

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

The growth appears to be more organic in terms of the consumer being the driver. We need to make sure it's followed up with additional more broad-based gains, said Daniel Penrod, a senior analyst at the California Credit Union League in Ontario, California.

MARKETS DISAPPOINTED

Markets were disappointed growth fell short of the 3.4 percent pace expected. That combined with reports of a federal probe of Goldman Sachs to send stocks tumbling on Wall Street.

Prices for U.S. government debt rose, tapping a safe-haven bid, while the dollar fell for a third day against the euro.

Consumer spending rose at a 3.6 percent rate in the January-March period, more than double the fourth quarter's 1.6 percent pace and the biggest gain since the start of 2007.

Consumers don't seem as panicked as they were last year and they are beginning to unleash some of the pent-up demand, said Ryan Sweet, a senior economist at Moody's Economy.com in West Chester, Pennsylvania.

But that pace of (spending) growth is unsustainable. We're going to see a more cautious consumer over the next few months because we still have a nearly double-digit unemployment rate.

The United States has emerged from recession more swiftly than Europe or Japan. Euro zone first-quarter GDP data due in mid-May 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.

FED SEEN ON HOLD

This should provide additional comfort for the majority on the (Fed's policy panel) that will look to keep rates on hold into 2011, said Joseph Brusuelas, chief economist at Brusuelas Analytics in Stamford, Connecticut.

The central bank on Wednesday noted activity had strengthened 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.

The Commerce Department report showed that business inventories increased $31.1 billion in the first quarter, adding 1.57 percentage points to GDP growth, as firms restocked to meet rising demand. It was the first inventory increase 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 and jobs.

If they are spending on equipment already, it shows a lot of confidence for 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 registered 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, with residential investment contracting at a 10.9 percent rate.

Business spending on structures subtracted from GDP for a sixth straight quarter. A bigger trade deficit as export growth slowed sharply also weighed on first-quarter GDP.

Signs of a durable economic recovery were bolstered by other reports showing manufacturing activity in the Chicago area rose to a five-year high and increased for a ninth month in New York City.

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

(Additional reporting by Patricia Zengerle; Editing by Dan Grebler)

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