The U.S. economy shrank less in the second quarter than first thought but negative news on jobs and on manufacturing in the country's Midwest in September pointed to a patchy recovery from recession.

Gross domestic product, which measures the total output of goods and services within U.S. borders, fell at a 0.7 percent annual rate instead of the 1.0 percent decline reported last month, the U.S. Commerce Department said on Wednesday.

It was the fourth straight quarter of decline in real GDP, but probably the last quarter of falling output. The U.S. economy, which slipped into recession in December 2007, is believed to have rebounded in the July-September quarter.

On the manufacturing front, however, the Institute for Supply Management-Chicago said its business barometer fell to 46.1 in September from 50.0 in August; a reading below 50 indicates contraction.

A separate survey by the ADP Employer Services showed private U.S. employers cut 254,000 jobs in September, more than the 210,000 financial markets had been expecting.

What it comes down to is how much of this recovery is going to be sustainable. I'm not a believer yet that this is a robust economy. This is going to be a very frustratingly weak growth period, said Robert MacIntosh, chief economist at Eaton Vance Corp in Boston.

The manufacturing and jobs data sent U.S. stocks tumbling, although buying in technology heavyweights limited losses. For the third quarter, the blue-chip Dow Jones industrial average <.DJI> recorded its best quarterly gain since the last three months of 1998 <.N>.

The mixed economic picture will probably result in the Federal Reserve -- the U.S. central bank -- holding its key overnight lending rate near zero percent for a long while.

Atlanta Fed president Dennis Lockhart said on Wednesday more evidence the economic recovery was sustainable was needed for the Fed to exit its extremely low interest rates and other policies designed to stimulate the economy.

In China and Japan factory activity rose while Germany reported an unexpected fall in unemployment.

MOVING IN THE RIGHT DIRECTION

The 0.7 percent fall in second-quarter U.S. GDP was better than market expectations for a 1.2 percent contraction and an improvement from the first quarter's 6.4 percent decline.

Today's revision of real GDP ... indicates that the economy has begun to stabilize, said Mark Doms, chief economist at the U.S. Commerce Department. The economy is moving in the right direction, and further stimulus spending should support this momentum in the coming months.

The shallow decline reflected more moderate drops in consumer spending and business investment than first thought.

Consumer spending, which accounts for over two-thirds of U.S. economic activity, fell at a 0.9 percent rate in the second quarter, down from the previously estimated 1.0 percent. Spending rose at a 0.6 percent rate in the first quarter.

Business investment fell at a 9.6 percent rate in the second quarter instead of 10.9 percent, reflecting slightly better demand for software than previously thought. It had slumped 39.2 percent in the first quarter.

Weak domestic demand meant businesses continued to reduce their stock of unsold goods. Inventories plunged by a record $160.2 billion in the second quarter rather than the $159.2 billion drop estimated by the government last month. Stockpiles of unsold goods fell by $113.9 billion in the first quarter.

The drop in inventories subtracted 1.42 percentage points from the second-quarter GDP change, the Commerce Department said. Excluding inventories, GDP rose 0.7 percent compared to a 4.1 percent decline in the first quarter.

Rebuilding of inventories is expected to be one of the main drivers of the economy's recovery.

Economists agree a recovery, aided by government spending, is under way but query its strength and sustainability because of weak consumer spending. The pace of job losses has slowed markedly but companies are still not hiring on a big scale.

The employment component of the Chicago PMI inched up to 38.8 in September from 38.7 in August.

We're seeing the economy turn, but it's most likely not going to be a vigorous turn. You will have setbacks and the numbers will ebb and flow, said Michael Moran, chief economist at Daiwa Securities in New York.

Residential investment, at the heart of the worst U.S. recession in seven decades, dropped at a 23.3 percent rate in the second quarter after falling 38.2 percent in the first.

Separate Commerce Department data showed weak domestic and global demand meant second-quarter corporate profits after taxes rose 0.9 percent, well below the 2.9 percent estimated last month. They rose 1.3 percent in the first quarter.

There was encouraging news on the trade front. Exports fell at a 4.1 percent rate instead of the 5 percent drop reported last month. Exports plunged 29.9 percent in the first quarter.

A survey by the National Association of Purchasing Management-New York showed business activity in New York City surged to a near three-year high in September, building on recent optimism about local conditions.

For a graphic comparing Midwest with U.S. manufacturing indexes, click on http://graphics.thomsonreuters.com/099/US_PMIMFI0909.gif (Additional reporting by Ros Krasny in Mobile, Alabama and Camille Drummond and Burton Frierson in New York; Editing by James Dalgleish)

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