The number of U.S. workers filing new applications for unemployment insurance unexpectedly surged last week, while producer prices increased sharply in January, raising potential hurdles for the economy's recovery.

Initial claims for state jobless benefits increased 31,000 to 473,000, the Labor Department said on Thursday. Financial markets had expected them to fall slightly to 430,000.

Another report from the department showed prices paid at the farm and factory gate rose a faster-than-expected 1.4 percent from December as higher gasoline prices and unusually cold temperatures helped boost energy costs.

The rise in jobless insurance claims dealt a setback to hopes the economy was on the verge of job growth and could increase political pressure on President Barack Obama, who has made tackling unemployment his number one priority.

The recovery is still intact, but it's going to be a long slog. The labor market and housing remain problematic, said Ryan Sweet, senior economist at Moody's Economy.com in West Chester, Pennsylvania.

Disappointment over the claims and producer inflation data was partially offset by reports showing stronger gains in factory activity in the U.S. Mid-Atlantic region and a 10th straight monthly rise in a gauge of the economy's prospects.

The Philadelphia Federal Reserve Bank's business activity index rose to 17.6 in February from 15.2 the prior month, while the Conference Board's index of leading economic indicators rose 0.3 percent last month after December's 1.2 percent gain.

The Federal Reserve, citing improvement in financial market conditions, announced on Thursday it would raise the interest rate it charges banks for emergency loans. The discount rate rises to 0.75 percent from 0.50 percent, effective Friday.

U.S. stock indexes ended higher on a batch of reassuring corporate earnings. However, stock index futures fell on news of the discount rate hike, which came after market close.

Treasury debt prices tumbled, weighed down in part by an announcement that the government would auction a record $126 billion worth of notes next week. The U.S. dollar, which has gained steadily on a stream of improving economic data in recent months, initially fell on the weak claims report, but reversed course on the discount rate news.

JOBS LAG RECOVERY

The hard-hit labor market has lagged the economic recovery that started in the second half of 2009. Gross domestic product grew at a 5.7 percent annual rate in the fourth quarter, but still failed to ignite jobs growth.

Initial claims have been flat over the last three months. That means the improvement in the labor market is much slower than suggested by the headline GDP figure, said Harm Bandholz an economist at Unicredit Research in New York.

That shows GDP growth is artificially inflated by government stimulus and the inventory cycle rather than driven by final demand, which usually goes hand in hand with an improvement in the labor market.

The economy has lost 8.4 million jobs since recession struck in December 2007.

Analysts noted the claims data covered the survey week for the government's report on employment for February, due early next month. That, along with snow storms that blanketed much of the nation in recent weeks, offered another reason to expect a weak report, they said.

Concerns about employment affected sales at Wal-Mart during the holiday quarter and the world's largest retailer said on Thursday that U.S. sales would be more challenging in the first quarter. It said its forecasts for the current quarter could miss Wall Street estimates.

Economists were caught by surprise by the strong rise in producer prices, but most said they did not expect the upward trend to be sustained, pointing to spare factory capacity and sluggish wage growth.

About three-fourths of the increase in PPI last month was due to a 5.1 percent jump in prices for energy goods. Energy costs were pushed up by a spike in prices for gasoline, liquefied petroleum and home heating oil.

Stripping out the volatile food and energy costs, core producer prices rose 0.3 percent last month after being flat in December. The core index, which had been forecast to rise 0.1 percent, was lifted by a surge light motor truck and pharmaceutical prices.

The PPI measurement of motor vehicle prices appears to be entirely disconnected from reality. It is a source of significant distortion in the monthly results that should be ignored, said David Greenlaw, an economist at Morgan Stanley in New York.

The department on Friday will release its consumer price report for January. Overall CPI is seen rising 0.3 percent from December and core CPI gaining 0.1 percent, according to a Reuters survey.

(Additional reporting by Lisa Lambert)

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