Other reports on Thursday showed home resales slumped to their lowest level in eight months in June and a gauge of future economic activity slipped last month.

"The data confirm that the economy has cooled off pretty considerably late in the second quarter and early in the third quarter from the pace we saw earlier in the year," said Omair Sharif, an economist at RBS in Stamford, Connecticut.

The economy has been hit by fears of deep government spending cuts and higher taxes next year, as well as troubles from the debt crisis in Europe, culminating in slower job growth, weak consumer spending and soft manufacturing output.

The Philadelphia Federal Reserve Bank said its business activity index for the mid-Atlantic region came in at a reading of minus 12.9 in July compared with minus 16.6 last month. A reading below zero indicates contraction in output in factories in eastern Pennsylvania, southern New Jersey and Delaware.

New orders dropped for a third consecutive month, and a gauge of employment declined sharply to a near three-year low.

Growth in U.S. factory output slowed to a 1.4 percent annual rate in the second quarter after a brisk 9.8 percent pace in the first three months of the year, and the Philadelphia Fed's regional factory index suggested a continued loss of momentum.

Joel Naroff, chief economist at Naroff Economic Advisors in Holland, Pennsylvania, said the biggest factor weighing on the recovery was fear that politicians in Washington would be unable to avoid the so-called fiscal cliff at the turn of the year.

"While there are real issues out there, such as Europe, what seems to be the overarching factor driving business decisions is the fear of a fiscal fiasco," Naroff said.

"Gridlock is no longer just a political game. It is having real economic effects. Until business leaders can plan with more certainty, there is little chance the economy can accelerate to a solid pace."

U.S. stocks shrugged off the dour economic data and rose for a third straight day, with the Standard & Poor's index touching a 2-1/2 year high as IBM gave an upbeat outlook and eBay posted stronger-than-expected earnings.

Prices for U.S. government bonds fell and the dollar dropped to a six-week low against the yen as worries about the euro zone debt crisis weighed.

TEPID JOB GROWTH

The Labor Department said initial claims for state unemployment benefits rebounded by 34,000 to a seasonally adjusted 386,000 last week. A seasonal quirk caused claims to drop by 24,000 in the prior week.

The four-week moving average, which provides a better measure of underlying trends, fell by 1,500 to 375,500 -- staying in the middle of the range it has held for much of 2012.

While volatility surrounding the timing of annual auto plant shutdowns for retooling makes it hard it get a reliable reading of the labor market from the claims data, economists said the report did not change views of tepid job growth.

"It looks like the labor market is in a similar state to what we saw before this volatility in the claims data began, but we won't have a clean signal for another few weeks," said Daniel Silver, an economist at JPMorgan in New York.

Last week's claims data covered the period for the government's employment count for July. The labor market has suffered three months of sub-100,000 job growth as employers put the brakes on hiring.

Federal Reserve Chairman Ben Bernanke told lawmakers this week that the U.S. central bank was watching the labor market closely and would take additional action to spur the recovery if needed.

There was also disappointing news on Thursday from the housing sector, which has been the bright spot in the economy.

Home resales dropped 5.4 percent to an annual rate of 4.37 million units last month, the National Association of Realtors said. However, the median sales price hit its highest level since September 2008.

With the economy showing little vigor, economists said the chances of the Fed launching a third round of bond purchases were on the rise.

"While we believe that economic conditions have not deteriorated sufficiently to push the Federal Reserve over the edge, the odds of further policy action being taken in the near-term have clearly risen," said Millan Mulraine, senior macro strategist at TD Securities in New York.

A Reuters survey published on Thursday put the chances of further bond purchases at 50 percent, up from 45 percent in June.

(Additional reporting by Jason Lange; Editing by Neil Stempleman and Leslie Adler)

• A Permanent Economic Emergency