U.S. output per worker rose at its fastest pace in six years during the second quarter as businesses wrung more productivity from fewer staff in a sign that a recovery from recession will be slow and unlikely to create a surge in hiring.

A Labor Department report on Tuesday showed non-farm productivity, a gauge of hourly output per worker, jumped at a 6.4 percent annual rate, the sharpest since the third quarter of 2003 after a 0.3 percent gain in the January-March quarter.

The bounce in productivity is another indication that the nasty U.S. recession is drawing to a close. The bad news is, however, that firms are still reluctant to hire, said Harm Bandholz, an economist at UniCredit Markets and Investment Banking in New York.

A separate government report showed U.S. wholesalers cut their inventories of unsold goods for a 10th straight month in July as businesses continued running as lean as possible in the face of uncertainty about how durable a recovery will be.

U.S. stocks fell and government bond prices rallied to session highs as investors worried businesses were cutting inventories sharply because they remained skeptical about a rebound in consumer demand.

The Dow Jones industrial average <.DJI> ended down 1 percent at 9,241.45 points, while the Standard & Poor's 500 index dropped 1.27 percent to 994.35 <.SPX>.

White House economic adviser Larry Summers said on Tuesday a foundation for economic recovery was being laid, but warned the economy still had a long way to go.

Analysts said the sustained drop in wholesale inventories posed a risk that second-quarter gross domestic product could be revised lower to show a annual rate of decline steeper than the 1 percent reported by the government last month.

We are lowering our estimate of the percent change in second-quarter real GDP from -1.2 percent to -1.8 percent, said Abiel Reinhart, an economist at JPMorgan in New York.

We also expect that the change in real business inventories in the second quarter will be revised down from what was already a record $141 billion decline (annual rate) to a $162 billion decline, he added.

DATA REASSURING FOR THE FED

The productivity data is likely to be reassuring for the Federal Reserve, as it indicates inflation remains muted.

The U.S. central bank is set to start a regular two-day meeting on Tuesday and is widely expected to leave overnight lending rates unchanged near zero.

It gives the Fed more room to keep rates lower for longer in order to move the economy as quickly as possible through the recovery phase to an expansion mode, said Brian Bethune, chief U.S. financial economist at IHS Global Insight in Lexington, Massachusetts.

The worst economic downturn in over 60 years has forced companies to aggressively cut costs -- mostly their work force -- to shield profits from further erosion. Since the start of recession in December 2007, about 6.7 million workers have been laid off, according to the latest government statistics.

Analysts said the surge in productivity helped to explain better-than-expected earnings from some companies, despite weak demand across all sectors of the economy.

Deeper cost cuts, including layoffs and plant closures, have helped companies such as Caterpillar Inc and 3M Co

to post better-than-expected second-quarter results.

Separately, the Commerce Department said that stocks at U.S. wholesalers plummeted 1.7 percent in June, driving inventories to their lowest level in more than two years.

The inventory-to-sales ratio fell to 1.26 months' worth from May's 1.28 months, the lowest ratio since October.

We believe that firms will continue to shed stocks in the second half of the year, but at a much more moderate pace, which implies a significant positive impetus to GDP, especially in the current quarter, said Stephen Stanley, an economist at RBS in Greenwich, Connecticut.

According to the productivity report, hours worked plunged at a 7.6 percent rate in the second quarter, while output fell 1.7 percent.

In a sign that inflation pressures remained benign and deflation was a threat, unit labor costs fell 5.8 percent, the biggest decline since the second quarter of 2000, after dropping a revised 2.7 percent in the January-March quarter.

Unit labor costs are closely watched by the Fed for hints of inflation. Compensation per hour rose at a 0.2 percent pace, but adjusted for inflation, it was down 1.1 percent.

The decline in wage costs will lead to a decline in prices, which is exactly the sort of downward wage-price spiral the Fed will be desperate to avoid, said Paul Ashworth, a senior U.S. economist at Capital Economics in Toronto.

The economy may be tentatively emerging from recession, but the threat of deflation will remain for some time.

Compared with the April-June quarter of 2008, non-farm productivity was up 1.8 percent. Unit labor costs fell 0.6 percent year-on-year. Compensation from a year earlier rose 1.3 percent and was up 2.2 percent once adjusted for inflation.

Output, measured on a year-on-year basis, was down 5.6 percent in July.

(Additional reporting by Lisa Lambert in Washington and Scott Malone in Boston; Editing by Neil Stempleman, Gary Crosse)

Inflation