* Dollar notches strongest month in over a year
* U.S. labor costs rise in second quarter
* U.S. weekly jobless claims just above expectations
* Traders eye U.S. nonfarm payrolls data for July (Adds comments, updates prices throughout)
By Sam Forgione
NEW YORK, July 31 (Reuters) - The U.S. dollar edged higher against a basket of major currencies on Thursday to notch its strongest monthly gain in over a year after U.S. labor market data fueled expectations for a more hawkish Federal Reserve.
The Labor Department said the Employment Cost Index, the broadest measure of labor costs - and one of Fed Chair Janet Yellen's favorite labor market gauges - rose 0.7 percent in the second quarter, marking the biggest increase in over 5-1/2 years.
U.S. weekly jobless claims, meanwhile, edged up to 302,000 in the latest week. While that was slightly above expectations, the four-week average of claims fell 3,500 to 297,250, their lowest since April 2006.
The U.S. dollar index hit a fresh 10-1/2-month high of 81.573 after the data, but pared most of its gains on profit-taking ahead of Friday's U.S. nonfarm payrolls data, which economists expect to show U.S. employers added 233,000 jobs in July.
"It's hard to be a dove in these circumstances and that's what the market is picking up on," said Steven Englander, global head of G10 foreign exchange strategy at CitiFX in New York, in reference to the Fed's stance on monetary policy.
Analysts have said the Fed may take a more hawkish stance on raising interest rates at its September policy meeting in light of the recovering U.S. economy. Higher rates are expected to boost the dollar by driving capital flows into the United States.
The euro last traded at $1.3388, down 0.06 percent against the dollar and just above an eight-month trough of $1.3372. The dollar was up 0.05 percent against the Japanese yen at 102.83 yen, and up 0.01 percent against the Swiss franc at 0.9085 franc.
Traders largely shrugged off data showing the pace of business activity in the U.S. Midwest in July sank to its slowest since June 2013. The Institute for Supply Management-Chicago business barometer tumbled to 52.6, below economists' expectations for a rise to 63.0.
The data showing continued strength in the U.S. labor market overshadowed the Chicago PMI reading, said Dennis DeBusschere, portfolio strategist at ISI Group in New York.
The U.S. dollar index, which measures the dollar against a basket of six major currencies, was last up 0.03 percent at 81.454. The index posted its biggest monthly gain in nearly 1-1/2 years of over 2 percent in July.
The yield on the U.S. benchmark 10-year Treasury note inched up to 2.56 percent. On Wall Street, the benchmark S&P 500 index was on track for its worst day since April on concerns over the strength of overseas economies and ongoing tensions with Russia. (Reporting by Sam Forgione; Editing by Dan Grebler, G Crosse)