U.S. business productivity grew at its fastest clip in six years in the third quarter and new claims for jobless aid fell to a 10-month low last week, suggesting the labor market may be starting to bottom out.

The Labor Department said on Thursday that productivity surged at a 9.5 percent annual rate, the quickest pace since the third quarter of 2003, as companies squeezed more output from a smaller pool of labor to hold the line on costs.

The Labor Department also reported that initial claims for state unemployment benefits dropped to 512,000 in the week ended October 31, the lowest level since early January. Markets had expected a decline to only 523,000, from the 530,000 reported in the prior week.

Some healing of the labor market is crucial to sustaining and strengthening the economy's recovery after its worst recession in 70 years, with employment key to underpinning consumer spending.

Analysts doubt that the rapid growth rate in productivity, which measures the hourly output per worker, can be sustained, which some analysts say means businesses may soon have to step up hiring to meet the demand for their goods and services.

We expect the pace of efficiency gains will soon begin to fade, said Michelle Girard, a senior economist at RBS in Greenwich, Connecticut. Having cut payrolls so dramatically during the last downturn, we believe that companies will be forced to add workers earlier in this recovery than was the case following the last two recessions.

U.S. stocks rallied on the reports, with the productivity data viewed as good news for company earnings. The blue chip Dow Jones industrial average gained more than 2 percent and closed above the 10,000 threshold for the first time in about two weeks.

Financial markets had expected productivity to rise at a 6.4 percent rate. It grew at a 6.9 percent pace in the April-June period, when the economy was still contracting.

MUTED INFLATION PRESSURES

The U.S. Federal Reserve on Wednesday held overnight interest rates close to zero percent and said it would keep them extraordinarily low as long as excess economic slack and a lack of inflation warning signs prevailed.

The U.S. economy grew in the third quarter for the first time in more than a year, driven largely by government stimulus. The strong productivity report suggested there was little need to worry about inflation at this juncture.

Unit labor costs, a measure of the cost of labor for any given amount of production, fell 5.2 percent last quarter after declining 6.1 percent the previous period. Analysts had forecast a drop of only 4 percent.

Solid productivity growth provides the basis for a recovery in business earnings and investment in the second half of 2009, and keeps a firm lid on prices and inflation, said Brian Bethune, chief U.S. financial Economist at IHS Global Insight in Lexington, Massachusetts.

They provide the Fed more room to keep rates exceptionally low for an extended period in order to coax the economy through the fragile recovery period over the next year and ultimately to an expansion mode.

Productivity in manufacturing rose at a record 13.6 percent rate in the third quarter, likely driven by automakers ramping up production to rebuild depleted stocks after the popular cash for clunkers program boosted sales.

Compensation per hour jumped at a 3.8 percent pace, but after adjustment for inflation it was up only 0.2 percent -- pointing to sluggish growth in income.

In the weekly jobs claims report, the four-week moving average for new benefit claims slipped 3,000 to 523,750 last week, the lowest in almost 10 months. The average, which is seen as a better gauge of underlying trends, has declined for nine straight weeks.

Still, claims remain high. Analysts say they need to drop below 400,000 to signal that the economy is creating jobs.

While the Labor Department is expected to report on Friday that the decline in employment slowed further in October, the jobless rate is expected to rise to 9.9 percent, up from a 26-year high of 9.8 percent in September.

Separately, most retailers' monthly sales in October lagged the market's optimistic expectations, but there were some encouraging signs that consumers were showing interest in buying more than the bare necessities.

There were further hints of labor market improvement in the data on Thursday. The number of people still on the jobless benefit rolls after collecting an initial week of aid dropped to the lowest level since March in the week ended October 24, the latest week for which data was available.

That decline implied the unemployment rate is probably approaching its peak, said Abiel Reinhart, an economist at JP Morgan in New York. We look for the unemployment rate to peak around 10.2 percent in early 2010.

(Editing by Leslie Adler)

Inflation Unemployment