(Adds details, market reaction)
* Weekly jobless claims rise 23,000
* Four-week average of claims lowest since 2006
* Labor costs post largest gain in more than 5-1/2 years
* Midwest factory activity slows sharply in July
WASHINGTON, July 31 (Reuters) - U.S. labor costs recorded their biggest gain in more than 5-1/2 years in the second quarter and a gauge of trends in the jobs market fell to an eight-year low last week, bolstering the economy's outlook.
Though economists cautioned against reading too much into the rise in the employment cost index, they said a tightening jobs market suggested wage growth was poised for further gains.
"If the unemployment rate keeps declining, compensation pressures simply have to increase. Most members of the Federal Reserve appear to believe it will be a lot later and not very rapidly but I am not that sure," said Joel Naroff, chief economist at Naroff Economic Advisors in Holland, Pennsylvania.
The Employment Cost Index, the broadest measure of labor costs, rose 0.7 percent, the Labor Department said on Thursday. That was the largest gain since the third quarter of 2008 and followed a 0.3 percent increase in the first quarter.
It is one of Fed Chair Janet Yellen's favorite labor market gauges and is being closely watched for clues on the timing of the first interest rate increase from the U.S. central bank.
Fed officials on Wednesday acknowledged the improvement in labor market conditions, but said "significant underutilization of labor resources" remained.
Economists, who had forecast the employment cost index increasing 0.5 percent in the second quarter, are critical of the Fed's views on the labor market, particularly wages, as anecdotal evidence of companies raising wages increases.
"We do expect to see a steady inflection higher in wage growth going forward that we think will call into question the Fed's contention," said Ted Wieseman, an economist at Morgan Stanley in New York.
In the 12 months through June, labor costs rose 2.0 percent. They had advanced 1.8 percent in the 12 months through March.
Wages and salaries, which account for 70 percent of employment costs, increased 0.6 percent in the second quarter. That was the largest gain since the third quarter of 2008 and followed a 0.3 percent rise in the first quarter.
Wages and salaries were up 1.8 percent in the 12 months through June after rising 1.6 percent in the 12 months through March. Benefit costs jumped 1.0 percent in the April-June period, the largest increase since the second quarter of 2011.
FIRMING LABOR MARKET
In another report, the Labor Department said the four-week average of initial claims for state unemployment benefits, considered a better gauge of labor market trends as it irons out week-to-week volatility, fell 3,500 to a seasonally adjusted 297,250 last week, the lowest level since April 2006.
While overall claims increased 23,000 to 302,000 last week, that reflected difficulties smoothing out volatility from the data around this time of the year because of automobile plant shutdowns for retooling.
"The pace of layoffs is slowing, reflecting the need on the part of companies to retain more workers in the context of improving economic activity," said Anthony Karydakis, chief economic strategist at Miller Tabak in New York.
The dollar edged higher against a basket of currencies, while prices for U.S. Treasury debt were marginally up. U.S. stocks were broadly weaker amid concerns over the strength of overseas economies and ongoing tensions with Russia.
The economy rebounded strongly in the second quarter after contracting in the first three months of the year. Growth is expected to remain on a faster path for the rest of the year.
Separately, the Chicago Business Barometer dropped 10.0 points to 52.6 in July, the lowest level in just more than a year. Managers, however, viewed the downturn, which was the largest since October 2008, as a lull rather than the start of a new downward trend. (Reporting By Lucia Mutikani; Additional reporting by Richard Leong in New York; Editing by Andrea Ricci)