The number of U.S. workers submitting new claims for jobless benefits fell sharply last week, fanning hopes the fragile labor market was on the mend and that the broader economy was stabilizing.

Initial claims for state unemployment insurance fell 38,000 to a seasonally adjusted 550,000 in the week ended August 1, the Labor Department said on Thursday, beating market expectations for a drop to 580,000.

In a sign that the trend was firmly toward a moderation in the pace of layoffs, the four-week moving average for new claims fell 4,750 to 555,250 in the week ended August 1.

The four-week moving average is considered a better gauge of underlying trends as it irons out week-to-week volatility. The moving average has declined for six consecutive weeks.

However, the number of people collecting long-term unemployment benefits rose by 69,000 to 6.31 million in the week ended July 25, though the four-week moving average declined for four straight weeks.

Analysts said the report, which followed data on Wednesday showing steeper private-sector job cuts and declining non-manufacturing employment in July, restored optimism that the labor market was starting to heal.

The U.S. labor market is on the mend. This corroborates our view that the pace of layoffs has slowed down noticeably, said Harm Bandholz, an economist at UniCredit Markets & Investment Banking in New York.

Hours after the figures were released, President Barack Obama declared that actions taken by his administration had helped stop an economic freefall and said the United States may be seeing the very beginnings of the end of the recession.

We're losing jobs at half the rate we were at the beginning of this year, Obama told a rally outside Washington for the Democratic candidate for Virginia governor. Our financial system is no longer on the verge of collapse. The market is up.

Earlier, top White House economic adviser Christina Romer cautioned, though, that economic recovery will be painful and that Friday's widely watched report on July unemployment likely will show hundreds of thousands more jobs were lost.

U.S. stocks fell as investors turned cautious on the day before the government's July unemployment data and took profits from a recent rally. The stock market had opened higher after the jobless report, but that optimism quickly faded. The Dow Jones industrial average ended down 24.71 points at 9,256.26, while the Standard & Poor's 500 index eased 5.64 points to 997.08 and the Nasdaq fell 19.89 points to 1,973.16.

RECESSION MAY BE WINDING DOWN

Government bond prices edged lower amid caution ahead of July's non-farm payrolls report on Friday. Analysts said the jobless claims data had improved the chances of a better non-farm payrolls report and may have signaled the 20-month-old recession was winding down.

The claims data are another sign that the recession could be behind us, said Kevin Flanagan, fixed income strategist for Global Wealth Management at Morgan Stanley in Purchase, New York.

I am optimistic that a recovery is in the process of beginning, but we will need to see continued improvement in claims going through (below) the 500,000 level before the consumer is willing to come on board and be part of the recovery, he added.

A Reuters survey forecast that Friday's U.S. Labor Department report will show 320,000 workers lost their jobs in July, the least for any month since September when employers cut 321,000 jobs.

But the July jobless rate may climb to 9.6 percent -- the highest since June 1983 -- from 9.5 percent in June, as employers remain reluctant to hire because of subdued demand.

Romer, who chairs the White House Council of Economic Advisers, said on Thursday the U.S. government's $787-billion stimulus program was stabilizing the economy despite unacceptable job losses that may continue for some time.

Unfortunately, even once GDP (gross domestic product) begins to grow, it will likely take still longer for employment to stop falling and begin to rise, she said.

Analysts said the sharp drop in jobless claims applications last week was more evidence that employers had cut way too many jobs as the economy sank in the first quarter.

Business overdid things earlier in the year. The huge layoffs we had were not justified ... we are anticipating that we will see (jobless claims) numbers like this frequently going forward, said Milton Ezrati, senior economist at Lord Abbett in Jersey City, New Jersey.

Labor market weakness is casting a shadow over the economy's recovery prospects from the worst recession in over 60 years as high unemployment exerts pressure on incomes, severely curtailing households' spending capacity.

Consumer spending is the main driver of U.S. economic activity and there are signs that shoppers may be coming back to the malls.

Some U.S. retailers on Thursday reported sales declines for July were not as steep as expected, although same-store sales were likely to fall for an 11th straight month.

(Additional reporting by David Lawder and Matt Spetalnick in Washington, John Parry in New York and Jessica Wohl in Chicago; Editing by Jan Paschal and Todd Eastham.)

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