WASHINGTON - 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 2003. 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.

The continued moderation in the pace of job losses offers some encouragement on the state of the U.S. labor market, said Millan Mulraine, economics strategist at TD Securities in Toronto.

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 9.5 percent after dipping to 9.4 percent in July.

Market reaction to the mixed data was modestly positive. U.S. stocks edged higher, while U.S. government bond prices fell on the hint of steady economic improvement.

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

Stubbornly high unemployment is wearing on consumer confidence and crimping spending, pointing to an anemic recovery from the recession that started in December 2007.

The unemployment 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 primary 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 in December 2007, the economy has shed 6.9 million jobs.

FEWER LAYOFFS

However, the August jobs report confirmed the pace of layoffs was easing from early this year. Nearly three-quarters of a million jobs were lost in January alone.

Manufacturing employment fell by 63,000 last month, pushing the total factory jobs lost since the start of the recession to 2 million. Construction industry payrolls dropped by 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 continued to add jobs, with payrolls increasing 52,000 in August after rising 21,000 in July. Government employment fell 18,000 after slipping 28,000 in July.

The average workweek, which closely correlates with overall output and gives clues on when firms will start hiring, was unchanged 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.

It certainly sustains perceptions that the economy gradually is swinging to recovery. The main pitfall would be continued weak income growth but that was not the case in August, so that's encouraging, said Pierre Ellis, senior economist at Decision Economics in New York.

(Additional reporting by Alister Bull in Washington and Ellen Freilich in New York; Editing by Andrea Ricci)

Unemployment