The U.S. economy grew at its fastest pace in 1-1/2 years in the fourth quarter, but a rebuilding of stocks by businesses and slower business spending warned of weaker growth in early 2012.

Gross domestic product expanded at a 2.8 percent annual rate, the Commerce Department said on Friday, a sharp acceleration from the 1.8 percent in the prior three months.

It was, however, a touch below economists expectations in a Reuters poll for a 3 percent rate, and two-thirds of the increase was due to the build-up in business inventories.

Soft underlying demand and a sharp slowing in core inflation supported the Federal Reserve's decision this week to keep in place an ultra easy monetary policy to nurse the recovery.

The areas of strength are unlikely to be strong in the current quarter and the areas of weakness are more than likely to be weaker, said Steve Blitz, a senior economist at ITG Investment Research in New York. Frankly, I don't think there is an awful lot the Fed can do about it.

The data helped push U.S. stocks slightly lower, while longer-dated Treasury debt prices are slipped. The dollar fell against a basket of currencies.

The economy got a temporary boost from the rebuilding of inventories, which logged the biggest increase since the third quarter of 2010.

Excluding inventories, the economy grew at a tepid 0.8 percent rate, a sharp step-down from the prior period's 3.2 percent pace and a sign of weak domestic demand.

THE POLITICS OF GROWTH

For all of last year, the economy grew just 1.7 percent, and economists expect only a bit of quickening this year.

Sluggish growth could hurt President Barack Obama's chances of re-election in November, and might lead the Fed to launch a further round of bond purchases to spur the recovery.

Clearly, much work remains to achieve the Fed's dual mandate of maximum sustainable employment in the context of price stability, New York Federal Reserve Bank President William Dudley told reporters.

The central bank on Wednesday said it expected to keep interest rates at rock bottom levels at least through late 2014, and it warned the economy still faced big risks, a suggestion the euro zone debt crisis could still hit hard.

U.S. Treasury Secretary Timothy Geithner on Friday also gave a lukewarm assessment of economy's prospects.

We're still repairing the damage done by the financial crisis. On top of that we face a more challenging world. We have a lot of challenges ahead in the United States, he said at the World Economic Forum in Davos.

STRENGTH AND WEAKNESS

The robust inventory accumulation in the fourth quarter - a $56 billion build-up - suggests the recovery will lose a step at some point in early 2012 when businesses throttle back.

But economists said there was no sign businesses were uncomfortable yet with the amount of inventory they had on hand, suggesting they could add more in the current quarter.

We had dealer stock build in the fourth quarter, but it was really to make sure we had the inventories that support the going-rate in terms of days' supply, Ford Motor Corp Chief Financial Officer Lewis Booth said on a conference call.

I think we're at 58 days, which is actually lower than our typical level, he said.

Weak spots during the quarter included business investment spending, which advanced at just a 1.7 percent annual rate, the slowest since 2009.

A sharp drop in defense spending and still weak outlays at state and local authorities combined to yield a fifth straight quarterly contraction in government spending.

Though exports held up, an increase in imports left a trade gap that also chipped growth, and while home construction rose at the fastest pace since the second quarter of 2010, it was helped by unseasonably mild winter weather.

SLUGGISH INCOME GROWTH

Consumer spending, which accounts for about 70 percent of U.S. economic activity, also accelerated, stepping up to a 2 percent rate from the third-quarter's 1.7 percent.

However, it was largely driven by pent-up demand for cars. The Japanese earthquake and tsunami had disrupted supplies early last year, leaving showrooms bereft of popular models.

Consumers also benefited from a moderation in inflation.

A price index for personal spending rose at a 0.7 percent rate in the fourth-quarter, the slowest increase in 1-1/2 years.

A core measure that strips out food and energy costs rose at a 1.1 percent pace, off sharply from the prior quarter and the slowest in a year. The slowdown could worry the Fed, which would prefer it nearer its 2 percent inflation target.

High unemployment has led to sluggish income growth, which in turn has prompted households to tap savings and credit cards to fund their purchases.

A sustained GDP growth pace of at least 3 percent would likely be needed to make noticeable headway in absorbing the unemployed and those who have given up the search for work.

Though the unemployment rate has improved, the jobs market remains a major challenge, said Adolfo Laurenti, deputy chief economist at Mesirow Financial in Chicago.

The high level of people out of the workforce and underemployed people show there isn't really much income generation to contribute to a better spending pattern.

Even so, another report on Friday showed consumer sentiment reached its highest level in nearly a year this month.

(Additional reporting by Ben Klayman in Detroit; Editing by Neil Stempleman and Tim Ahmann)

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