Manufacturing activity in the U.S. mid-Atlantic region in February expanded at its fastest pace in nearly two years, a report saidThursday, indicating that the hard-hit factory sector is gradually pulling out of a deep slump.

While manufacturing activity appears to have bottomed after contracting for more than a year, the report said firms remained cautious about making future investments and continued to shed jobs, suggesting the recovery will be sluggish.

The Federal Reserve Bank of Philadelphia said its February business conditions index rose to 16.0 from 14.7 in January, hitting its h bottoming out of the region's manufacturing sector," the report said.

"Optimism about growth in the manufacturing sector over the next six months remains high, although the outlook for employment growth and capital spending remains more cautious," it said.

The closely watched new orders index, a gauge of future activity, rose to 13.7 in February, its highest level since May 2000, from 12.6 in January. With inventories lean, manufacturers fill new orders by increasing production.

But the employment index fell further on the month to -14.7 from -9.3 a month earlier, indicating that manufacturers continue to shed employees to cope with the slowdown.

U.S. Treasuries dipped briefly on the report, while U.S. stocks and the dollar showed no reaction.

Since mid-2000, manufacturers nationwide have shed more than 1.5 million workers as firms sharply cut back on production to deal with a huge build-up of unsold goods. Factories have slashed inventories at a record pace, and economists believe manufacturers are poised to ramp up activity.

The inventories index posted a 16th straight month of contraction but eased the pace of decline, rising to -14.8 in February from -17.9 in January, suggesting that the worst of the record-paced inventory liquidation has passed.

The report said optimism about growth in the manufacturing sector over the next six months remains high, even though the survey's outlook index slipped slightly in February, to 51.8 from 53.2 in January.

The Philadelphia Fed, one of the nation's 12 regional Fed banks, serves Delaware, eastern Pennsylvania and southern New Jersey -- a highly industrialized region that is considered a bellwether for national manufacturing activity.

The Business Outlook Survey is a diffusion index compiled by subtracting the number of companies reporting decreases from those reporting increases.