By Joanne Morrison

WASHINGTON (Reuters) - U.S. worker productivity raced ahead in the first quarter at the fastest pace in almost 19 years as profit-hungry businesses squeezed more from their employees instead of taking on new hires amid a patchy economic recovery, a government report on Tuesday showed.

The 8.6 percent surge in nonfarm hourly worker output reported by the U.S. Labor Department (news - web sites) trounced Wall Street's expectations and likely helped tamp down inflation fears for Federal Reserve (news - web sites) officials, who hours later opted to leave interest rates steady at 40-year lows.

"Inflation is nowhere to be found and labor costs are clearly in a sweet spot," said Anthony Chan, chief economist at Banc One Investment Advisers in Columbus, Ohio.

While businesses have managed to boost productivity and keep labor costs down, they are also showing some comfort with inventory levels after cutting them sharply in recent months.

A separate government report showed stocks on U.S. wholesalers' shelves were unchanged in March, breaking a string of nine monthly declines. The Commerce Department (news - web sites) report said the stock-to-sales ratio, which measures how long it would take to deplete inventories at the current pace of sales, held steady at 1.27 months.

"The period of drawdowns is probably behind us, but it's not clear how anxious (wholesalers) are going to be to rebuild inventories," said Michael Moran, chief economist at Daiwa Securities America in New York.

Business investment is crucial to keeping the economic recovery moving, economists and Fed officials believe.

Manufacturers are indeed optimistic about the next six months, expecting some modest revenue growth of 2.8 percent in the second half of the year, according to the Institute for Supply Management's latest semiannual report.

However, more job cuts could be in the picture as businesses tread water and operate well below capacity, the survey said, adding to concerns about job market weakness.

MARKETS SHOW LITTLE REACTION

Shorter-dated U.S. Treasuries moved a bit higher after the Fed acted according to expectations and left short-term interest rates unchanged at four-decade lows.

In a statement issued after its meeting, the Fed's Federal Open Market Committee (news - web sites) (FOMC) cited an "uncertain" outlook for business and consumer demand and said risks to the economy remained balanced between inflation and weakness.

The statement's overall wording indicated concern about recent soft economic data which have included a rise in the April unemployment rate to the highest level in more than 7-1/2 years amid signs of continued weakness on the labor front.

"We are in a critical year with a considerable amount of uncertainly and they didn't want to rock the boat," Chan added.

Stocks gave up much of their early gains after the Fed decision, with the Dow Jones ending up about 28 points after rising more than 100 points earlier in the day. The tech-laden Nasdaq composite index ended down more than four points.

"They (the Fed) called it as they saw it, which is at this point they are willing to have a very liberal monetary policy," said David Laster, an economist with Swiss Re in New York.

Economists said the productivity numbers all but cemented a belief that inflation right now is nonexistent and the Fed has ample time to allow the economy to improve before raising interest rates.

The showing for productivity, the best in nearly two decades, will likely help create conditions for better corporate profits -- key to keeping business spending growing.

"It certainly alleviates one of the Fed's bigger concerns, that is weak corporate profitability. Obviously ... plunging labor costs will help that tremendously and subsequently help boost much-needed investment spending," said Richard Yamarone, Chief Economist with Argus Research Corp in New York.

BEST PRODUCTIVITY GROWTH SINCE 1983

The Labor Department said productivity, or worker output of goods and services per hour outside the farm sector, grew in the first three months of the year at the fastest clip since logging 9.9 percent growth in the second quarter of 1983.

That was after revised 5.5 percent productivity growth in the final quarter of 2001.

"Some may call this a jobless recovery. I call it an efficiency upturn. Businesses have spent the last year restructuring and managing their work forces cautiously. It is paying off," said Joel Naroff of Naroff Economics in Holland, Pa.

White House economic aide Glenn Hubbard agreed, saying strong first-quarter productivity growth indicated that big gains in worker output in recent years were "more or less permanent."

Hubbard, chairman of the White House Council of Economic Advisers, said the first-quarter gain was a good sign for the sustainability of the economic recovery and helped explain why consumers have been so optimistic. "In the long term, a more productive economy is a growing economy, and that's a job creator," he said.

Unit labor costs, a closely watched gauge of wage pressures, fell 5.4 percent during the quarter. It was the steepest decline since a 6.5 percent decline in the second quarter of 1983. In manufacturing, unit labor costs declined by 6.5 percent, the biggest falloff in more than 40 years.