WASHINGTON (Reuters) - U.S. existing home sales unexpectedly increased in February as rising supply pulled buyers back into the market, but rising economic uncertainty could limit further gains.

Home sales rose 4.2% last month to a seasonally adjusted annual rate of 4.26 million units, the National Association of Realtors said on Thursday. Economists polled by Reuters had forecast home resales would drop to a rate of 3.95 million units.

The increase occurred despite drops in pending contracts, which lead sales by a month of two, in December and January when the average rate on the popular 30-year fixed-rate mortgage was hovering around 7%. Sales were boosted by a favorable seasonal adjustment factor last month. They fell 1.2% on a year-on-year basis in February.

"Home buyers are slowly entering the market, said Lawrence Yun, the NAR's chief economist. "Mortgage rates have not changed much, but more inventory and choices are releasing pent-up housing demand."

While the average rate on a 30-year fixed-rate mortgage had declined to about 6.65% by mid-March, the economic outlook has dimmed.

Consumer and business sentiment have dropped amid President Donald Trump's often chaotic trade policy, marked by on-again, off again tariffs on imports from the nation's major trade partners. The administration's unprecedented campaign to drastically shrink the federal government through mass firings and deep spending cuts could also weigh on the housing market.

The Federal Reserve held its benchmark overnight interest rate in the 4.25%-4.50% range on Wednesday, though U.S. central bank policymakers indicated they still anticipate reducing borrowing costs by half a percentage point by the end of this year.

The inventory of existing homes increased 5.1% to 1.24 million units in February. Supply rose 17% from a year ago. The median existing home price increased 3.8% from a year earlier to $398,400 in February, a record for the month.

At February's sales pace, it would take 3.5 months to exhaust the current inventory of existing homes, up from 3.0 months a year ago. A four-to-seven-month supply is viewed as a healthy balance between supply and demand.

Properties typically stayed on the market for 42 days last month compared to 38 days a year ago. First-time buyers accounted for 31% of sales, up from 26% a year ago. Economists and realtors say a 40% share is needed for a robust housing market.

All-cash sales constituted 32% of transactions, down from 33% a year ago. Distressed sales, including foreclosures, made up 3% of transactions, creeping up after hovering around 2% in recent years.

(Reporting by Lucia Mutikani; Editing by Paul Simao)