The pace of U.S. job losses slowed sharply last month, the strongest sign to date that the recession is diminishing, even as the unemployment rate hit its highest in nearly 26 years.

The Labor Department said on Friday that U.S. employers cut 345,000 jobs in May, the fewest since September and far less than economists had forecast. They cut 504,000 jobs in April.

However, the unemployment rate raced to 9.4 percent, the highest since July 1983, from 8.9 percent in April, partly because people who had given up looking for work re-entered the labor market, a sign economic confidence was returning.

It keeps hopes alive for a full recovery in the U.S. economy by the second half. It's a step in the right direction, said John Canally, investment strategist and economist for LPL Financial in Boston.

U.S. stocks pushed higher on the data, while bond prices fell and the dollar rose on the view the Federal Reserve -- the U.S. central bank -- may need to begin withdrawing its extraordinary monetary support from the recession-pummeled economy before year-end.

The relatively small decline in payrolls fell far shy of the 520,000 drop expected by financial markets, sparking market rumors that the government had published incorrect figures, speculation dismissed by Labor Department officials.

Some market participants said the department's adjustments to a model estimating the creation of new ventures and the destruction of old ones had led to an overstatement in employment. But economists said this argument was flawed.

The U.S. recession, now in its 18th month, is the longest since the Great Depression and has wiped out six million jobs, although March and April data were revised to show 82,000 fewer jobs were lost in those months than previously reported.

BRIGHTER LIGHT

The light at the end of the tunnel just got a lot brighter. May's employment report brings clear evidence that the labor market is beginning to stabilize, said Nigel Gault, chief U.S. economist at IHS Global Insight in Lexington, Massachusetts.

A raft of recent data -- from gains in home sales to rising consumer confidence -- had already fueled optimism that economic growth would resume in the second half of the year.

While the job losses in May were spread across almost all sectors, the pace of layoffs was slower than in prior months.

Construction jobs fell 59,000 after dropping 108,000 in April, likely as a result of the government's $787 billion stimulus package.

The service-providing side of the economy shed 120,000 positions after eliminating 230,000 in April. Manufacturing purged 156,000 jobs in May, possibly reflecting auto plant shutdowns in the wake of Chrysler's bankruptcy filing. The sector had shed 154,000 positions in April.

Analysts said firms had aggressively cut jobs in response to sagging demand and were now finding less fat to trim.

Education and health services payrolls rose by 44,000 after increasing 13,000 the prior month. The leisure and hospitality industry, which had been shrinking consistently, added 3,000 jobs.

Government, which in April added 92,000 jobs mostly related to preparations for the 2010 census, cut 7,000 in May.

Analysts said they expect the payrolls contraction to keep easing in the months ahead. The jobless rate, however, is not expected to peak until it hits about 10 percent next year.

Also in May, a surge in new labor force entrants combined with a drop in employment to push the jobless rate up a sharper-than-expected half-percentage point.

This is a reminder that getting the unemployment rate down will be a long, drawn-out task, as workers who had previously given up their job search return to the labor force, said Gault. But the worst news is behind us, and job declines should progressively soften as the year proceeds.

In a reminder of the labor market's weakness, the length of the average work week eased to 33.1 hours from 33.2 in April.

Average hourly earnings climbed to $18.54 from $18.52, putting earnings 3.1 percent above their year-ago level, but still the smallest 12-month gain since the period ended November 2005.

A gauge of labor market slack that measures both the unemployed, people working part-time for economic reasons and those only marginally attached to the labor force hit a record high of 16.4 percent in May from 15.8 percent in April.

(Editing by Dan Grebler)

Chrysler Unemployment