U.S. job losses were the smallest in a year last month, but the unemployment rate unexpectedly jumped to a 26-year high, according to data on Friday that showed the labor market limping toward health.

The Labor Department said the jobless rate climbed to 9.7 percent in August, the highest since June 1983. The increase suggests consumer spending will remain weak and impede the economy's recovery from the worst recession in seven decades.

Employers cut 216,000 jobs, the smallest since August 2008, but payroll losses in June and July were 49,000 more than initially estimated, the department said.

Things are much better than they were six months ago, but the patient is still somewhat sick and on the road to recovery. The recession ended probably somewhere around June, but the recovery is going to be muted, said Jack Bauer, a senior economist at Manning & Napier in Rochester, New York.

Analysts had expected non-farm employers to cut 225,000 workers from their payrolls in August and had looked for the unemployment rate to rise to only 9.5 percent after dipping to 9.4 percent in July.

U.S. stocks initially fell as investors took a dim view at the surge in the unemployment rate. But by midday, the three major U.S. stock indexes were up about 1 percent as the focus turned to the smaller-than-expected decline in employment. U.S. government bond prices fell on the hint of steady economic improvement.

The trajectory is in the right direction, White House economic adviser Christina Romer told CNBC television.

While the economy appears to have pulled out of the recession it fell into in December 2007, unemployment is expected to continue to mount for the next several months.

The jobless rate in August was partially lifted by the return to the labor force of some jobless workers who had given up looking for work, but the main cause was a big drop in employment.

A gauge of labor market slack that measures both the officially unemployed and discouraged jobseekers rose to a record 16.8 percent in August from 16.3 percent in July.

Since the start of the recession, the economy has shed 6.9 million jobs. The government has rolled out a $787 billion package of spending and tax cuts to rescue the economy.

On Thursday, Vice President Joe Biden said the stimulus package had created or sustained 150,000 jobs in its first 100 days and would add 600,000 more during its second 100 days.

FEWER LAYOFFS

The jobs report confirmed the pace of layoffs had eased from early this year. Nearly three-quarters of a million jobs were lost in January alone.

Manufacturing employment fell 63,000 last month, pushing the total number of factory jobs lost since the start of the recession to 2 million. Construction industry payrolls dropped

65,000 after falling 73,000 in July.

The service-providing sector purged 80,000 workers in August, while goods-producing industries shed 136,000 positions. Education and health services added 52,000 jobs in August after increasing payrolls by 21,000 in July.

We are on track to break even on jobs by the end of the year and will be producing positive jobs growth in the first part of ... 2010, said Phil Orlando, chief equity market strategist at Federated Investors in New York.

Still, Orlando cautioned that consumer spending, which normally accounts for about two-thirds of U.S. economic activity, was likely to be sluggish for some time.

The consumer is going to lag. The pieces that are going to drive this recovery are strong overseas growth, the weak dollar and export growth, which is going to drive a sharp inventory growth commencing this quarter.

The length of the average workweek, which closely correlates with overall output and gives clues on when firms will start hiring, held steady at 33.1 hours in August.

Average hourly earnings rose to $18.65 in August from $18.59 in July. It was the fourth straight monthly gain, reflecting an increase in the legal minimum wage.

(Additional reporting by Alister Bull; Editing by Jan Paschal)

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