The U.S. economy contracted in the second quarter at a slower pace than previously thought, while a surprise slide in manufacturing activity in the country's Midwest region in September pointed to a patchy recovery from recession.

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

This was better than market expectations for a 1.2 percent contraction and an improvement from the first quarter, when GDP fell at a 6.4 percent rate.

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, with a reading above 50 indicating expansion. Economists had expected a rise to 52.0.

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.

A separate survey by the ADP Employer Services showed private employers cut 254,000 jobs in September, more than the 210,000 layoffs the market had been expecting. However the decline was less than the 277,000 jobs lost in August.

U.S. stocks briefly rose on the GDP report, but gave up gains upon seeing the weak Chicago manufacturing survey, with all three major stock indexes down more than one percent. But Treasury bond prices rose, as these securities are seen as a safe-haven in times of economic uncertainty.

The decline in GDP will probably mark the last quarter of contracting output for the U.S. economy, which slipped into recession in December 2007. The economy is believed to have rebounded in the July-September quarter.

Today's revision of real GDP in the second quarter 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.

With the second-quarter contraction, the country's real GDP has shrunk for four straight quarters for the first time since government records started in 1947.

SHALLOW CONTRACTION

The shallow decline in activity in the second quarter reflected more moderate drops in consumer spending and business investment than previously thought.

Consumer spending, which normally accounts for over two-thirds of U.S. economic activity, fell at a 0.9 percent rate in the second quarter -- smaller than the previously estimated 1.0 percent decline. Spending rose at a 0.6 percent rate in the previous 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 tumbled 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 second-quarter GDP, the department said. Excluding inventories, GDP rose 0.7 percent in the second quarter 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 the recovery, aided by government spending, is under way but there are doubts over its strength and sustainability because of weak consumer spending. While the pace of job losses has slowed markedly, companies are still not hiring on a bigger scale.

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

We're just starting to get numbers on September now. 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.

Investment in nonresidential structures fell at a 17.3 percent rate compared to a 43.6 percent drop in the January-March quarter. 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 quarter.

Separate Commerce Department data on Wednesday showed that weak domestic and global demand meant second-quarter corporate profits after taxes rose 0.9 percent, much lower than the 2.9 percent estimated last month. They increased 1.3 percent in the first quarter.

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

In New York, 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 economic conditions.

(Additional reporting by Ros Krasny, Camille Drummond and Burton Frierson; Editing by Chizu Nomiyama)

Manufacturing