Factory activity in Middle Atlantic states braked sharply in April and the number of Americans claiming new jobless benefits fell less than expected, implying the economy was struggling to regain momentum.

Other data on Thursday showed steep declines in home prices in February, underscoring the challenges confronting the economy, but the recovery is expected to remain on track.

The reports came a week before government data is expected to show growth slowed significantly in the first quarter. The economy grew at a 2.0 percent annualized rate, according to a Reuters survey, after a 3.1 percent pace in the last three months of 2010.

The economy certainly lost some steam through the first quarter, (but) the underlying health remains sound, said Brian Levitt, an economist for OppenheimerFunds in New York. It's an economy that is likely to grow, but out-sized growth is not on the horizon.

The Philadelphia Federal Reserve Bank's business activity index fell to 18.5 in April, pulling back from March's 27-year high of 43.4 and far exceeding economists' expectations for a drop to 37.

The index covers Pennsylvania, southern New Jersey and Delaware and is an early indicator of the health of U.S. manufacturing contained in a later national report.

Separately, the Labor Department said initial claims for state unemployment benefits fell 13,000 to a seasonally adjusted 403,000 last week, well above economists' expectations for a decline to 392,000.

The slowdown in economic activity comes as some policymakers at the Federal Reserve are pushing for the U.S. central bank to start considering withdrawing some of the stimulus it has provided the economy.

The Fed's policy-setting committee will meet April 26-27 to assess the economy and is expected to reaffirm a June end date for purchases of $600 billion of government bonds.

Thursday's economic data curtailed stock market gains, which began with a flurry of strong corporate earnings. Treasury debt prices rose marginally, while the dollar fell against a basket of currencies.

Economists said it was possible supply disruptions in the aftermath of the devastating earthquake and tsunami in Japan could have hindered U.S. factory activity and kept initial unemployment claims elevated as some automakers idled plants.

PLANTS IDLED

While affected individuals can file claims for unemployment insurance when these plants close temporarily, it is unlikely that workers were laid off for the entire payroll period, meaning they would still count as employed in the payroll survey data, said Daniel Silver, an economist at JPMorgan in New York.

The claims data covered the survey period for April's nonfarm payrolls report, which will be released in early May. Employers added 216,000 jobs in March, the most in 10 months, and the unemployment rate slipped to a two-year low of 8.8 percent from 8.9 percent.

The smaller-than-expected drop in claims last week left the total above 400,000 for a second straight week. Claims below that level are usually associated with fairly solid jobs growth.

A third report showing home prices fell 1.6 percent in February from January provided more evidence of the headwinds buffeting the economy. On a year-over-year basis, home prices fell 5.7 percent.

Despite the sharp pullback in April, mid-Atlantic factory activity has now expanded for seven months in a row. Economists did not view the report as a sign that manufacturing, which as led the economic recovery, was slowing.

A report last week showed a gauge of manufacturing in New York state rose in April to its highest level in a year.

The Philadelphia Fed survey also showed steep declines in new orders and the employment measure, which were both the lowest since December. It also showed a surge in prices received by manufacturers, a potential warning on inflation.

The Fed might also be concerned to see that the prices received index climbed sharply even though output growth seems to be tailing off and the prices paid index dropped back a little, said Paul Ashworth, chief U.S. economist at Capital Economics in Toronto.

It appears manufacturers are testing out their pricing power.

While the economy slowed in the first three months of 2011, it is expected to continue expanding. The Conference Board's Leading Economic Index rose 0.4 percent in March to 114.1, rising for a ninth straight month.

(Additional reporting by Lisa Lambert in Washington and Leah Schnurr in New York; Editing by Kenneth Barry)

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