NEW YORK - The U.S. services sector contracted in November, with an index measuring activity falling to its lowest reading since July, according to a report released on Thursday that was a shock to economists forecasting the economic recovery was gathering pace.

The services sector news offset a report showing new applications for U.S. jobless benefits unexpectedly fell last week to the lowest level in more than 14 months, suggesting a labor market edging toward stability, while revised data showed productivity was less robust in the third quarter.

Later in the New York trading day, the White House said it has seen signs that the U.S. unemployment rate to be announced on Friday might tick upward, spokesman Robert Gibbs said on Thursday at a news briefing.

It's a disappointing number, said Gary Thayer, chief macrostrategist at Wells Fargo Advisors in St. Louis Missouri of the ISM report.

Manufacturing is being helped by low inventories, but the service sector is taking longer to get a turnaround started.

The Institute for Supply Management said its services index shrank to 48.7 in November from 50.6 in October. That was slightly below the 51.5 median forecast of 62 economists surveyed by Reuters. A reading above 50 indicates expansion in the sector.

The services sector represents about 80 percent of U.S. economic activity and includes businesses such as banks, airlines, hotels and restaurants.

U.S. stock indexes pared gains after the report, U.S. Treasury debt prices pared losses, and the euro pared gains against the U.S. dollar.

LABOR CONCERNS

Meanwhile the labor market, which is seen as the biggest threat to the economy's recovery from the worst recession since the 1930s, is being closely watched. Particularly ahead of the payroll report to be released at 8:30 a.m. EST (1330 GMT) on Friday.

Initial claims for state unemployment aid slipped 5,000 to 457,000 from 462,000 in the prior week, the U.S. Labor Department said on Thursday. Claims have dropped for five consecutive weeks. Analysts polled by Reuters had forecast claims rising to 480,000.

Now we have had two weeks in a row clearly below 500,000. That is very encouraging. In order to move from net loss of jobs into positive payrolls territory we need to get down to about 400,000 in claims. We are half way there, said Jay Mueller, senior portfolio manager at Wells Capital Management in Milwaukee, Wisconsin.

The government employment data on Friday is expected show that job losses moderated sharply in November and likely support views the deterioration in payrolls is in its final stages. Analysts polled by Reuters forecast U.S. employers cut 130,000 jobs last month after reducing payrolls by 190,000 in October.

The unemployment rate is seen steady at a 26-1/2 year high of 10.2 percent.

U.S. motorcycle maker Harley-Davidson Inc said on Thursday it had ratified a new labor agreement with employees represented by the International Association of Machinists and Aerospace Workers, that involves a near 50 percent cut in jobs, the company said in a statement.

OTHER REPORTS

In other reports, U.S. retailers from Macy's to Costco posted much weaker-than-expected sales for November as shoppers focused only on big bargains at the start of the key holiday selling season.

Out of 15 retailers that reported by early Thursday, 11 missed analyst estimates, including Costco Wholesale Corp, Children's Place, Walgreen Co and Hot Topic Inc, according to Thomson Reuters data.

Separately, the Department of Labor reported, that third-quarter non-farm productivity rose at an 8.1 percent annual rate, still the quickest pace since the third quarter of 2003, rather than the 9.5 percent rate predicted last month.

Aggressive cost cutting by businesses has pushed productivity sharply higher over the past months.

That, combined with a surge in profits during the quarter, has convinced analysts that companies may start hiring and help the economy's recovery.

OFFICIALS SEE ECONOMY IMPROVING

U.S. Treasury Secretary Timothy Geithner on Thursday said the economy was slowly healing, but he told CNBC that given there were still problems in the housing market and credit remained tight, economic problems were far from over.

Federal Reserve Chairman Ben Bernanke, making a case for a second term, told Congress on Thursday the U.S. central bank's forceful actions prevented a devastating financial crisis from being even worse.

The Federal Reserve's actions have contributed substantially to the significant improvement in financial conditions and to what now appear to be the beginnings of a turnaround in both the U.S. and foreign economies, he said in testimony prepared for delivery to the Senate Banking Committee at a hearing on his renomination to be Fed chair.

Bernanke, whose first four-year term at the helm of the central bank expires on January 31, faces an unusually high level of opposition from lawmakers critical of the Fed's actions leading up to and during the financial crisis.

Even so, his confirmation does not appear in doubt.

(Additional reporting by Lucia Mutikani, Glenn Somerville and Mark Felsenthal in Washington D.C.)

Ben Bernanke Unemployment Fall