WASHINGTON (Reuters) – New US claims for jobless aid rose last week while consumer prices notched their largest decline in nearly one-and-a-half years in May, suggesting interest rates will remain ultra low to nurse the fragile economic recovery.

Fears growth was slowing were heightened by news yesterday that factory activity in June in the country's Mid-Atlantic region braked to its slowest pace in ten months.

Analysts had generally expected the recovery from the most painful recession since the 1930s to moderate in the second half of this year as a boost from a rebuilding of business inventories and massive stimulus from the government faded.

"We are seeing that now. It is slowing as the temporary lifts from the stimulus and inventories recede, but not something that is consistent with a contraction of the economy," said Keith Hembre, chief economist at First American Funds in Minneapolis, Minnesota.

Absent a credit shock from the sovereign debt crisis that started in Greece, analysts do not expect the domestic economy to slip back into recession. Belt-tightening by European governments already looks set to slow economies there and take a small bite out of US growth.

For the labour market, the recession's biggest casualty, head winds are proving problematic. Initial claims for state unemployment benefits increased 12,000 to 472,000 last week as manufacturing, construction and education sectors shed workers, the Labour 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, and suggested a soft reading on private payroll growth. In a second report, the department said the Consumer Price Index fell 0.2 percent last month, the largest drop since December 2008, after dipping 0.1 percent in April. This came as gasoline prices fell by the most in 17 months.

"The economy may be expanding, but at a pace that isn't inspiring and any concerns about upward price pressure for US consumers in the near term are dissipating," said Jim Baird, chief investment strategist at Plante Moran Financial Advisors in Kalamazoo, Michigan.

The sluggish growth pace was underscored by the Philadelphia Federal Reserve Bank's business activity index which dropped to 8.0 this month from 21.4 in May. That was well below expectations for 20.9. A reading above zero indicates expansion in the region's manufacturing.

An employment measure in the survey dropped to a seven month low, although orders rose. Manufacturing has been boosted by businesses rebuilding inventories, which were liquidated to record low levels during the recession.

A record $787 billion stimulus package from the government also boosted demand, but analysts believe its effect on spending has longed peaked.

Stocks on Wall Street fell on the claims and factory data, brushing aside a government bond auction in Spain that attracted strong-than-expected demand. US government debt prices rose, while the dollar fell to three-week lows against the euro.

Although some fatigue is starting to show in the recovery, it appears firmly intact. 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.

After falling rapidly last year, jobless claims have stabilised at troublingly high levels. 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 some time.

A near ten 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 to hold overnight interest rates exceptionally low for "an extended period" when policymakers meet on Tuesday and Wednesday.

The US central bank is not seen lifting rates, currently near zero, until next year.

"The Fed's job is very straightforward – provide maximum monetary accommodation," said Brian Bethune, chief US financial economist at IHS Global Insight in Lexington, Massachusetts. "This will reduce short-term risks of a fall back and provide a basis for a gradual strengthening in the underlying momentum of the economy."

Last month, core inflation, which excludes the volatile energy and food prices and is closely watched by Fed officials, edged up 0.1 percent after being flat in April.