The contraction in the U.S. services sector eased last month, with a gauge of activity hitting its highest point in nearly a year, a further suggestion that a modest economic recovery was under way.

The Institute for Supply Management said on Thursday that its non-manufacturing index climbed to 48.4 in August, the highest since September last year, from 46.4 in July. But the sector remains in recession.

A separate report from the Labor Department showed initial claims for state unemployment insurance benefits fell 4,000 to 570,000 last week, hinting at only a marginal slowing in the fast pace of layoffs.

The continued shrinking in the services sector, which constitutes 80 percent of U.S. economic activity, was a disappointment to analysts after a report this week showed manufacturing that same month grew for the first time in 18 months.

We have entered recovery, but the data we have seen today ... does suggest the recovery will be muted through 2010 and we don't expect to see robust growth in excess of 4 percent until 2011, said Joseph Brusuelas, an economist at Moody's in Westchester, Pennsylvania.

U.S. stocks edged higher as news that lower-priced domestic retailers posted better-than-expected sales results in August offset investor disappointment over the jobless claims and services sector reports. U.S. government bond prices fell.

Sales at stores open at least a year fell an average of 2.9 percent at the 30 retailers tracked by Thomson Reuters, better than the 3.8 percent decline analysts had forecast.

While a wide range of economic data has signaled that the deepest U.S. recession in 70 years has likely ended, high unemployment has held back consumer spending, raising concerns that any recovery would be tepid.

While the pace of layoffs has slowed considerably from early this year, companies are reluctant to start aggressively hiring before they see stronger signs the recovery will be sustained.

A government report on the jobs market slated for release on Friday is expected to show employers shed another 225,000 workers last month after eliminating 247,000 positions in July.

The lack of job creation remains a big headwind for cash-starved and credit-constrained consumers, and thus a major impediment for the fledgling recovery, said Sal Guatieri, a senior economist at BMO Capital Markets in Toronto.

Highlighting companies' reluctance to expand payrolls, the number of people still on the benefit rolls after at least an initial week of aid rose 92,000 to 6.23 million in the week ended August 22, the Labor Department said on Thursday.

The insured unemployment rate, which measures the percentage of the insured labor force who are jobless, inched up to 4.7 percent in the week ended August 22 from 4.6 percent in the prior week.

This is consistent with the idea that employers are nervous that the economy is growing only because of policy stimulus, and that when the stimulus fades it will weaken again, said Ian Shepherdson, chief U.S. economist at High Frequency Economics in Valhalla, New York

(Additional reporting by Brad Dorfman in Chicago; Editing by Chizu Nomiyama)