By Lucia Mutikani
WASHINGTON (Reuters) - The U.S. economy grew faster than initially estimated in the third quarter but weak demand and a pile-up in business inventories buoyed the case for the Federal Reserve to keep up its bond-buying stimulus for now.
Gross domestic product grew at a 3.6 percent annual rate instead of the 2.8 percent pace reported a month ago, the Commerce Department said on Thursday.
It was the biggest gain since the first quarter of 2012, but inventories accounted for almost half of the increase in growth.
"The strong third-quarter growth pace masks the more subdued tone in domestic activity, and as the bloated level of inventory is worked off, we are likely to see a much softer performance in growth in the fourth quarter," said Millan Mulraine, senior economist at TD Securities in New York.
Businesses accumulated $116.5 billion worth of inventories during the quarter, the most since the first quarter of 1998.
The big build-up suggested firms were surprised by a lack of demand. Domestic demand rose at just a 1.8 percent rate, instead of the 2.1 percent the government reported last month.
Against this backdrop, economists said the Fed would likely remain cautious about trimming its asset purchases, even though recent signs on the labor market, including data on Thursday that showed a big drop in new claims for jobless benefits, suggest the economy is strengthening.
"I am not prepared to interpret the revised third quarter number as an indication that the economy is on a much stronger track," Atlanta Federal Reserve Bank President Dennis Lockhart, a policy centrist at the central bank, told reporters.
"I think we're still on that relatively moderate growth track."
Fed officials have been buying $85 billion in bonds each month to keep borrowing costs low. Most economists do not expect them to taper their purchases until March, although some speculate they could move at their next meeting on December 17-18.
SETTING UP FOR A WEAK Q4
Speculation the central bank might curtail its bond buying soon pushed yields on U.S. government debt to three-month highs. U.S. stocks were trading lower, while the dollar was weaker against a basket of currencies.
The strong inventory accumulation in the face of slowing domestic demand means businesses will likely need to draw down on stocks, which would weigh on GDP growth this quarter. Orders for manufactured goods fell 0.9 percent in October, a separate report showed.
Fourth quarter growth estimates are already on the low side, with a 16-day shutdown of the government in October expected to shave off as much as half a percentage point from GDP.
Many economists, whose fourth-quarter growth estimates are currently below a 2 percent rate, warned that the inventory bulge posed a downside risk to their forecasts.
Growth in consumer spending, which accounts for more than two-thirds of U.S. economic activity, was revised down to a 1.4 percent rate, the lowest since the fourth quarter of 2009. It had previously been estimated to have increased at a 1.5 percent pace.
A sluggish start to the holiday shopping season offered another reason for caution on the economy's near-term prospects. Several big U.S. retailers reported disappointing November sales, with some relying on bargains to lure shoppers.
But recent data have also offered reason for optimism.
A report from the Labor Department showed initial claims for state unemployment benefits dropped 23,000 to a seasonally adjusted 298,000 last week.
It was the third straight weekly drop and confounded economists' expectations for an increase to 325,000.
The report was the latest suggestion the labor market is gaining momentum. A report on Friday is expected to show that nonfarm payrolls increased 180,000 last month and the unemployment rate fell to 7.2 percent from 7.3 percent.
The Commerce Department also said that corporate profits after tax increased at a 2.6 percent pace in the third quarter, slowing from the prior quarter's 3.5 percent pace.
(Reporting by Lucia Mutikani, additional reporting by Jonathan Spicer in Fort Lauderdale, editing by Krista Hughes)