The U.S. services sector contracted in November to its lowest reading since July, according to a report released on Thursday that shocked economists forecasting the economic recovery was picking up steam.

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.

The White House said after the report it has seen signs that the U.S. unemployment rate that will be released on Friday might tick upward, spokesman Robert Gibbs said at a news briefing.

It's a disappointing number, said Gary Thayer, chief macrostrategist at Wells Fargo Advisors in St. Louis, referring to 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 well below the 51.5 median forecast of 62 economists surveyed by Reuters. A reading above 50 indicates expansion in the sector.

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

(For a graphic on the ISM report, see http://link.reuters.com/myf84g)

U.S. stock indexes pared gains after the report, U.S. Treasury debt prices trimmed losses, and the euro cut gains against the U.S. dollar. <.SPX>

ALL EYES ON THE JOB MARKET

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. The U.S. November non-farm payrolls report will be released on Friday.

Initial claims for state unemployment aid slipped 5,000 to 457,000 from 462,000 in the previous 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 halfway there, said Jay Mueller, senior portfolio manager at Wells Capital Management in Milwaukee.

The government employment data on Friday is expected show that job losses moderated sharply in November and probably will support views that the shrinkage 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.

President Barack Obama is hosting a forum on Thursday with business leaders at the White House to discuss how to increase jobs after U.S. unemployment hit a 26-year peak of 10.2 percent in October. But the gathering has been dismissed by critics as a public relations exercise. The jobs forum is set to begin at 1:30 p.m.

In yet more evidence of the weak labor market, U.S. motorcycle maker Harley-Davidson Inc said on Thursday it had ratified a new contract with the machinists' union representing employees at its largest factory that involves job cuts of almost 50 percent.

AN ECONOMY SLOWLY ON THE MEND

U.S. retail sales also were being eyed for clues on the economy's health.

As of Black Friday, which was the day after Thanksgiving and marked the start of the holiday shopping season, analysts had forecast a 2.5 percent rise in November sales at stores open one year, according to Thomson Reuters data. But estimates have shrunk since the weekend, and as of Wednesday, analysts expected an increase of only 2.1 percent.

That would still be the best showing since April 2008 and it marks a shift in gears from a drop of 7.8 percent in 2008, the worst drop since Thomson Reuters began tracking data in 2000.

U.S. Treasury Secretary Timothy Geithner said on Thursday 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 U.S. senators on Thursday at a hearing on his nomination for a second term as Fed chief that the U.S. central bank's forceful actions prevented a devastating financial crisis from being even worse.

Under his tenure, the Fed has slashed interest rates close to zero and pumped more than $1 trillion into the financial system to beat back the worst financial crisis since the Great Depression.

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