A bigger-than-expected rise in U.S. workers filing new claims for jobless aid last week underscored how fragile the labor market remains even as a measure of economic prospects hit a two-year high last month.

Initial claims for state jobless insurance increased 11,000 to 531,000 last week, the Labor Department said on Thursday, after falling for two consecutive weeks. Financial markets had expected new claims to be 515,000.

Separately, the Conference Board said its index of leading economic indicators rose 1.0 percent to 103.5, the highest since October 2007, but optimism over the robust increase was tempered by a report showing that home prices fell 0.3 percent in August.

The data confirm an overall picture of a gradual economic improvement, but we are not seeing it in the commercial real estate and jobs markets, said Larry Milstein, head of government and agency trading at R.W. Pressprich & Co in New York.

Investors on Wall Street brushed aside the mixed economic data, focusing instead on solid quarterly earnings reports, including from the world's largest hamburger chain, McDonald's Corp , and diversified manufacturer 3M Co .

The blue chip Dow Jones industrial average <.DJI> ended up 131.95 points, or 1.33 percent at 10,081.31 <.N>. U.S. government bond prices fell as the Treasury announced a record $123 billion worth of note sales next week.

While data and earnings reports from some companies strongly indicate the economy started growing again in the July-September period after four quarters of decline, persistently high unemployment has raised questions about the recovery's durability.

White House economic adviser Lawrence Summers told Reuters in an interview on Wednesday the economy was set for a recovery but cautioned that the pace of growth might be moderate and the job market would not revive immediately.

SIGNS OF HEALING

Analysts reckon the Federal Reserve, which is holding U.S. overnight interest rates near zero, will want to see labor markets beginning to heal before it withdraws its massive aid to the economy.

Boston Federal Reserve Bank President Eric Rosengren said on Thursday that the economy would grow reasonably in the second half of this year but added that the Fed needed to see more progress before taking some of its economic support away.

Separately, Federal Reserve Bank of Chicago President Charles Evans said the economy should grow about 3.0 percent over the next 18 months, but cautioned that unemployment posed a big challenge.

The U.S. unemployment rate rose to a 26-year high of 9.8 percent in September and is seen rising above 10 percent 2010.

Jobless claims last week were probably influenced by the October 12 Columbus Day holiday, which could have resulted in some laid off workers not filing their claims during that holiday week. Analysts say weekly jobless claims have to fall to 400,000 for payrolls show growth.

For a related graphic see: http://graphics.thomsonreuters.com/109/US_JOBLES1009.gif

Still, the pace of job losses has moderated considerably from early this year. The four-week moving average for new jobless claims fell by 750 to 532,250 last week, the lowest level since mid-January, the Labor Department said.

It was the seventh straight week of decline in the four-week average, which is considered a better gauge of underlying trends.

Among other encouraging signs, the number of people collecting long-term unemployment benefits in the week ended October 10 dropped to the lowest since March. This measure has trended lower for five straight weeks.

Analysts view this steady decline as a sign unemployment might be close to peaking but it could also reflect the fact that many jobless workers have exhausted their benefits.

The number of people receiving government-funded emergency unemployment aid rose to 3.39 million in the week ended October 3 from 3.35 million previously, the department said.

Even as we anticipate that the economy likely grew in the third quarter, the excess slack in the system and employers' hesitance to ramp up hiring appear likely to weigh on the labor markets for some time, said Jim Baird, chief strategist at Plante Moran Financial Advisors in Kalamazoo, Michigan.

The insured unemployment rate, which measures the percentage of the insured labor force that is jobless, edged down to 4.5 percent in the week ended October 10 from 4.6 percent the prior week, the department said.

Another hopeful sign was provided by a Labor Department report that showed the number of mass layoffs, defined as job cuts involving at least 50 people from a single employer, fell by 129 to 2,561 last month.

(Additional reporting by Emily Kaiser and Tim Ahmann in Washington and Richard Leong in New York)

Unemployment