A surge in productivity slowed in the first quarter, hinting that employers may soon need to step up hiring after months of squeezing more output from a smaller pool of workers.

Data on Thursday also showed new applications for unemployment benefits fell slightly last week, indicating the job market continues to improve only slowly even as the economic recovery shows some signs of broadening out.

They came ahead of Friday's employment report, expected to show payrolls grew for a second month in April.

Nonfarm productivity rose at an annual rate of 3.6 percent in the first quarter, while unit labor costs fell 1.6 percent, the Labor Department said.

That's good news for profits, since it means that sales improvements are going straight through to the bottom line, said Nigel Gault, chief U.S. economist at IHS Global Insight in Lexington, Massachusetts.

When or whether employers will start hiring more aggressively is at the heart of a debate on how solid recovery is in the world's biggest economy after 8.2 million Americans lost their jobs during the worst downturn since the 1930s.

The productivity number beat expectations for a 2.5 percent rise in the first quarter but Gault and others said they expected productivity growth to slow through 2010, as employers find it harder to squeeze more out of the existing workforce.

That (slower growth) will mean more hours worked and more hiring, boosting labor incomes, but the turnaround in the labor market is likely to be only a gradual one, he said.

In the fourth quarter, productivity increased at a rate of 6.3 percent, while unit labor costs, a gauge of inflation and profit pressures closely watched by the Federal Reserve, fell 5.6 percent.

In a second report, the Labor Department said initial claims for state unemployment benefits dropped 7,000 to a seasonally adjusted 444,000. Markets had expected claims to fall slightly further, to 440,000.

The pace of layoffs is clearly slowing, but on the hiring side, firms seem to be adding to their payrolls only gradually, said Omair Sharif, an economist at RBS in Stamford, Connecticut.

STOCKS COLLAPSE ON GREEK WOES

U.S. financial markets were little moved by the reports as attention focused on developments in Greece.

Stocks on Wall Street posted their largest percentage decline since April last year amid disappointment that the European Central Bank had stopped short of taking additional measures to keep Greece's debt crisis from spreading in the euro zone.

All three major U.S. stock indices ended down more than 3 percent. U.S. Treasury debt prices rallied and the benchmark 10-year note yield, which moves in the opposite direction, was on track for its biggest single-day drop in about nine months. The U.S. dollar hit a 14-month high against the euro.

The claims data has no direct bearing on Friday's jobs data, as it falls outside the survey period. A Reuters survey predicted nonfarm payrolls increased 200,000 last month following March's 162,000 gain. The employment rate is expected to have held steady at 9.7 percent for a fourth month.

Recruiting firm Monster Worldwide Inc also reported a rise in its gauge of online demand for labor in the United States for a third straight month in April, posting its largest year-on-year percentage gain since July 2007.

The upbeat numbers were tempered, however, by a report showing U.S. store chains posted disappointing April same-store sales, casting doubt on whether a rebound in consumer spending will be sustained.

Still, optimism over the economic outlook continues to grow. St. Louis Federal Reserve Bank President James Bullard said the economy was well into a recovery process but added it wasn't time yet to lift the U.S. central bank's pledge to keep interest rates very low for an extended period.

No, I don't think so. I've just tried to stress that it's important to have a .... policy that emphasizes that everything depends on how the economy evolves, Bullard said.

The economy grew at an annual pace of 3.2 percent in the first quarter, slowing from a 5.6 percent inventory-induced spurt in the fourth quarter.

Thursday's productivity data also showed total nonfarm output grew at a 4.4 percent rate in the January-March period after a robust 7.0 percent pace in the fourth quarter.

Hours worked edged up at a 0.8 percent rate, the highest since the second quarter of 2007, from 0.7 percent in the fourth quarter, further evidence that the recovery is progressing.

(Writing by Lucia Mutikani; Additional reporting by Mark Felsenthal; Editing by James Dalgleish)

Manufacturing