New U.S. claims for jobless benefits tumbled to a near two-year low last week, but a modest gain in industrial output and a third monthly drop in wholesale prices in June confirmed a slackening in the economy's recovery.

Other data on Thursday also implied the slowdown in manufacturing extended into July, but analysts said there was no evidence the economy was sliding back into recession.

The numbers are consistent with a slowdown in the rate of growth in the U.S. and the global economy, but not a double dip, said Nigel Gault, chief U.S. economist at IHS Global Insight in Lexington, Massachusetts. The evidence is not saying we have lapsed; the factory indicators are still pointing to growth.

Initial claims for state unemployment benefits dropped 29,000 to 429,000 last week, the lowest level in 23 months, as seasonal layoffs at factories eased, the Labor Department said. That was well below market expectations for a fall to 450,000.

In a second report, the department said producer prices fell 0.5 percent last month as gasoline prices dropped and food costs recorded their largest decline since April 2002.

Stripping out food and energy costs, prices edged up 0.1 percent after increasing 0.2 percent in May.

The relatively good news on employment was overshadowed by a Federal Reserve report showing industrial production rose 0.1 percent last month, braking sharply from May's 1.3 percent advance. Manufacturing output declined 0.4 percent, snapping a three-month streak of gains.

That weakness probably persisted this month, with measures of factory activity in New York state and the mid-Atlantic region slowing sharply from June. Growth in New York state was the slowest in seven months, while expansion in the mid-Atlantic region retreated to levels last seen in August.

Stocks on Wall Street initially fell on the sluggish manufacturing, but recouped losses to end flat as financial shares rose on reports the Securities Exchange Commission was going to settle fraud charges with Goldman Sachs .

But the data ignited a government bond rally, which pushed the yield on the two-year Treasury note to an all-time low. The U.S. dollar index <.DXY>, which measures the greenback against six major currencies, hit a two-month low.

RECOVERY LOST MOMENTUM

The manufacturing reports reinforced views that the recovery from the worst recession since the 1930s lost momentum in the past few months -- much sooner than most economists had expected. The data followed a report on Wednesday showing a second monthly decline in retail sales in June.

We are in this economic environment now where it's one step forward, one step back. We will skate along the bottom with slow growth for a long time, said Howard Simons, a strategist at Bianco Research in Chicago.

The recovery that started in the second half of 2009 has been largely driven by the rebuilding of inventories from record low levels and government stimulus, which spurred consumption by households. The inventory cycle appears to be running its course and the flow of stimulus money is slowing.

The Fed trimmed its 2010 growth forecast at its last policy-setting meeting in June. Many private economists have cut growth estimates for the second quarter and the full year.

We are pausing a bit in the recovery because the scramble to rebuild inventories is coming to an end and we are depending on underlying demand growth, which is fairly slow. But I don't think it's negative, IHS Global Insight's Gault said.

The moderation in factory activity in the mid-Atlantic region reflected a drop in new orders. Employment measures in both New York and the mid-Atlantic region both pulled back this month and working hours were reduced.

Labor market weakness, characterized by a 9.5 percent unemployment rate, is putting a damper on consumer spending.

A decision by manufacturers such as General Motors, who normally shut down their plants this time of year for retooling, to continue production helped to reduce the number of people filing for unemployment benefits last week.

A Labor Department official said the drop in claims was not restricted to the auto industry, but manufacturing as a whole, a factor some analysts believed could result in industrial output picking up this month after June's small gain.

Last week, the four-week moving average of new jobless claims, considered a better measure of underlying labor market trends, fell 11,750 to 455,250.

With inflation subdued due to weak energy prices, high unemployment and ample spare industrial capacity, analysts believe the Fed will keep overnight interest rates near zero until the second half of next year.

Industrial capacity in use held steady at 74.1 percent, up sharply from a year earlier, but still 6.5 percentage points below its average from 1972 to 2009, the Fed said.

The combination of sluggish manufacturing and producers' inability to raise prices has some economists worried that deflation is stalking the economy.

(Additional reporting by Emily Kaiser, Editing by Chizu Nomiyama)

Unemployment Fall Manufacturing