New claims for jobless aid rose last week while consumer prices notched their largest decline in nearly 1-1/2 years in May, suggesting interest rates will remain ultra low to nurse the fragile economic recovery.

Fears that growth could be slowing were heightened on Thursday by a report showing factory activity in the country's Mid-Atlantic region braked to its slowest pace in 10 months in June. The employment gauge fell to its lowest level since November.

I don't know if this is temporary, related to everything that has been going on in the markets, or if this means that the recovery is slowing, said Alan Lancz, president of Alan B. Lancz & Associates in Toledo, Ohio.

Financial markets have been worried that a debt crisis that started in Greece could spread. Belt-tightening by European governments already looks set to slow economies there and take a small bite out of U.S. growth.

For a labor market that is struggling to recover from the deepest U.S. recession since the 1930s, the head winds are proving problematic.

Initial claims for state unemployment benefits increased 12,000 to a seasonally adjusted 472,000 as manufacturing, construction and education sectors shed workers, the Labor Department said.

Financial markets had expected claims to fall to 450,000. Last week's data was in the survey period for the government's closely monitored employment report for June. A Labor Department official said states had reported claims in manufacturing, construction and education sectors.

In a second report, the department said its seasonally adjusted Consumer Price Index fell 0.2 percent last month, the largest decline since December 2008, after dipping 0.1 percent in April.

MODERATE RECOVERY

The rise in jobless claims is consistent with the view that the recovery is going to be fairly moderate. We are not going to get the kind of job growth and therefore GDP growth, which is going to generate inflation, said Jim Demasi, chief fixed income strategist at Stifel Nicolaus & Co. in Baltimore.

The Philadelphia Federal Reserve Bank's business activity index dropped to 8.0 in June from 21.4 in May. That was well below economists' expectations for 20.9. A reading above zero indicates expansion in the region's manufacturing.

Stocks on Wall Street fell on the claims and factory data, brushing aside Spain's auction of government bonds, which attracted strong demand. U.S. government debt prices rose, while the dollar fell to three-week lows against the euro.

Though the recovery is showing some weakness, expansion continues at a moderate pace.

The Conference Board's leading index, which tries to predict future levels of economic activity, rose 0.4 percent to a record 109.9 in May, after stagnating in April, another report showed.

After falling rapidly last year, jobless claims have made little progress in 2010.

Analysts see this as a sign that while layoffs have abated, companies are still not confident enough to add to payrolls, indicating unemployment will remain uncomfortably high for sometime.

A near 10 percent unemployment rate is hurting President Barack Obama's approval ratings, and dissatisfaction with the economy could cost the Democratic Party control of Congress in November's mid-term elections.

With unemployment still high and inflation pressures muted, the Federal Reserve is expected to extend its pledge for low interests rates. The U.S. central bank, which meets on Tuesday and Wednesday, is not seen lifting overnight interest rates from near zero until next year.

Consumer prices had been forecast to slip 0.2 percent in May. In the 12 months to May, the CPI rose 2 percent, slowing from the 2.2 percent rise the prior month, also in line with market expectations.

In May, energy prices fell 2.9 percent, the largest decline in more than a year. With energy costs falling, gasoline prices tumbled 5.2 percent - the biggest drop since December 2008. Food costs were flat for the first time since October.

Excluding the volatile energy and food prices, the closely watched core measure of consumer inflation edged up 0.1 percent after being flat in April.

Analysts had expected core prices to rise 0.1 percent. The monthly core inflation rate was bumped up by increases in costs at hotels and motels, and for apparel, tobacco, medical care and used vehicles.

In the 12 months to May, the core inflation rate rose 0.9 percent after increasing by the same margin in April. The rise was also in line with market expectations.

(Reporting by Lucia Mutikani, additional reporting by Pedro Nicolaci da Costa)

Manufacturing Inflation Unemployment Price