By Lucia Mutikani

WASHINGTON (Reuters) - U.S. economic growth rebounded strongly in the third quarter amid a shrinking trade deficit, but that overstates the economy's health as domestic demand was the weakest in two years because of the Federal Reserve's aggressive interest rate hikes.

The Commerce Department's advance third-quarter gross domestic product report on Thursday also showed residential investment contracting for a sixth straight quarter as the housing market buckles under the weight of surging mortgage rates. While overall inflation slowed substantially from the second quarter, price pressures continued to bubble.

Still, the rebound in growth after two straight quarterly declines in GDP was further evidence that the economy was not in a recession, though the risks of a downturn have increased as the Fed doubles down on rate hikes to battle the fastest-rising inflation in 40 years.

"Despite the shiny headline number, a look under the hood shows a much grimmer picture of the U.S. economy, one that is clearly losing steam," said Sal Guatieri, a senior economist at BMO Capital Markets in Toronto. "With the full effect of past and future Fed rate hikes still to be felt, the economy appears poised for a modest downturn in the first half of next year."

Gross domestic product increased at a 2.6% annualized rate last quarter after contracting at a 0.6% pace in the second quarter. Economists polled by Reuters had forecast GDP growth rebounding at a 2.4% rate. Estimates ranged from as low as a 0.8% rate to as high as a 3.7% pace.

The trade deficit narrowed sharply in part as slowing demand curbed the import bill. Exports also increased for much of the quarter. The smaller trade gap added 2.77 percentage points to GDP growth, the most since the third quarter of 1980.

Final sales to private domestic purchasers, which exclude trade, inventories and government spending, edged up at a 0.1% rate, a sign that higher borrowing cost were starting to erode demand. That was the slowest rise in this measure of domestic demand since the second quarter of 2020 and followed a 0.5% rate increase in the second quarter.

The data will likely have little impact on monetary policy, though Fed officials could draw some comfort from the ebbing demand. September personal consumption expenditures price data and third-quarter labor cost numbers due on Friday could carry more weight ahead of the Fed's Nov. 1-2 policy meeting.

The U.S. central bank has raised its benchmark overnight interest rate from near zero in March to the current range of 3.00% to 3.25%, the swiftest pace of policy tightening in a generation or more.

U.S. stocks opened higher. The dollar rose against a basket of currencies. U.S. Treasury prices were higher.

CONSUMER SPENDING SLOWS.

Growth in consumer spending, which accounts for more than two-thirds of U.S. economic activity, slowed to a 1.4% rate from the April-June quarter's 2.0% pace. Business spending on equipment rebounded solidly, while government expenditures ended five straight quarters of decline.

Consumer spending is being supported by a strong labor market, which is driving up wages. The Labor Department reported on Thursday a modest rise in the number of people filing new claims for unemployment benefits last week.

Initial claims for unemployment benefits increased 3,000 to a seasonally adjusted 217,000 for the week ended Oct. 22. Claims have remained significantly low despite reports of companies, mostly in the interest-rate-sensitive sectors of the economy, laying off workers.

There was some encouraging news on the inflation front. A measure of inflation in the economy rose at a 4.6% rate, decelerating from a 8.5% pace of increase in the second quarter.

As a result, income at the disposal of households after accounting for inflation rebounded at a 1.7% pace after decreasing at a 1.5% rate in the second quarter.

But inflation remains uncomfortably high. The personal consumption expenditures price index excluding the volatile food and energy components rose at a 4.5% rate after increasing at a 4.7% rate in the prior quarter.

Inventories remained a drag on growth. Economists worry that a rising stockpile of unsold goods could trigger a recession.

Retailers are finding themselves saddled with excess merchandise, because of easing supply chain bottlenecks and ebbing demand for goods, forcing them to offer discounts, which economists say may not be enough.