By Lucia Mutikani

WASHINGTON, May 29 (Reuters) - The U.S. economy contracted slightly less than initially estimated in the first quarter, while corporate profits rebounded, according to a government report on Friday that pointed to moderation in the recession.

Perceptions that the worst of the 17-month old downturn was over pushed consumer confidence to its highest level in eight months in May. A report showing business activity in New York City expanded in May for the first time since January 2008 offered a further hint the recession was abating.

Gross domestic product, which measures total goods and services output within U.S. borders, dropped at a 5.7 percent annual rate in the first quarter, the Commerce Department said, less than the initial 6.1 percent estimate. The decline followed a 6.3 percent contraction in the fourth quarter.

While the drop in activity was still steep, recent data have suggested the rate at which the economy was tumbling was easing and many economists expect growth to resume by year-end.

Still, output has declined for three straight quarters for the first time since 1974-1975 in a contraction that is the deepest since at least the 1950s. Already, the recession is the longest since the Great Depression, although much less severe.

"The recession is easing. The second quarter is shaping up to be a smaller decline of about 3.0 to 3.5 percent. It should be the last of the negative quarters," said Christopher Low, chief economist at FTN Financial in New York.

But the positive outlook for the economy was tainted somewhat by a report showing business activity in the country's Midwest unexpectedly fell sharply in April, likely reflecting troubles in the automotive sector.

That report caused U.S. stocks to surrender earlier gains, while government bond prices rose modestly.

The report on GDP suggested sharp belt tightening by business was paying off as corporate profits after taxes increased 1.1 percent in the first quarter, the first increase in a year. In the fourth quarter, profits had plummeted 10.7 percent, the biggest decline since the start of 1994.

LESSENING INTENSITY

"It provides some hints that maybe corporations might have the ammunition to put some money to work in the economy," said Michael Strauss, chief economist at Commonfund in Connecticut.

"We are seeing some signs that the intensity of the recession is lessening. It increases the potential that the third and more likely the fourth quarter probably return to positive growth."

Economic activity in the first quarter was dragged down by cutbacks in spending by businesses and the federal government, a further retrenchment in homebuilding and a drop in business investment spending, as well as a slump in exports.

Business inventories fell $91.4 billion after slipping by $25.8 billion in the fourth quarter. Last month, the department estimated the drop in inventories at a record $103.7 billion in the first quarter.

Inventories subtracted 2.34 percentage points from the overall GDP figure. Excluding inventories, GDP would have contracted 3.4 percent.

The decline in the stock of unsold goods is seen as a positive development as the sooner businesses trim inventories the sooner they will begin placing new orders.

Exports fell at a 28.7 percent pace, the largest decline since the fourth quarter of 1971, after dropping at a 23.6 percent rate in the fourth quarter.

The drop in exports lopped off a record 3.86 percentage points from GDP, and reflected the slump in global demand. Sluggish domestic demand saw imports plunging 34.1 percent, adding a record 6.05 percentage points to first quarter GDP.

Business investment spending tumbled a record 36.9 percent and homebuilding activity fell 38.7 percent, the biggest decline since the second quarter of 1980.

Consumer spending, which accounts for over two-thirds of U.S. economic activity, rose 1.5 percent -- slower than the 2.2 percent rate estimated last month -- but a welcome turnaround after a sharp plunge in the second half of last year.

Spending could pick up further in the months ahead as households grow more optimistic about the economy.

The Reuters/University of Michigan Surveys of Consumers' sentiment gauge rose to 68.7 in May from 65.1 in April. That was the highest reading since September. For details see

Separately, the National Association of Purchasing Management-New York's local business conditions index rose to 361.6 in May from 356.0 the previous month.

(Additional reporting by Richard Leong and Ellen Freilich in New York and Ros Krasny in Chicago, Editing by Andrea Ricci)

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