Investors will be closely watching Friday's employment report for further signs that the US economy is slipping into a recession.
Economists expect the report to show the economy shed a total of 60,000 jobs in March after losing 63,000 the month before. The unemployment rate, meanwhile, is expected to rise to 5.0 percent from 4.8 percent.
Worries about the jobs report grew after government data on Thursday showed that the number of U.S. workers applying for unemployment benefits soared by 38,000 last week,posting the highest reading since September 2005.
Analysts fear a housing slump and credit crunch may have tipped the U.S. economy into recession and are scrutinizing the labor market for evidence of slackening jobs that could chill consumer spending.
Federal Reserve Chairman Ben Bernanke warned on Wednesday that unemployment would push up as the U.S. economy slowed in the first half of the year.
The Fed has slashed interest rates 3 percentage points since mid-September to shield the economy from the housing slump and investors think it will cut again at its next scheduled policy meeting, at the end of this month.
"Further actions will have to depend on how the economy evolves," Bernanke told a U.S. Senate Banking Committee hearing on the rescue of troubled investment bank Bear Stearns. "We are looking of course at both sides of our mandate, growth and inflation."
Interest rate futures contracts currently imply investors fully expect the Fed will cut by a quarter percentage point, to 2.0 percent, at its next scheduled policy meeting, on April 29-30.
But they give only a 20 percent chance the Fed would cut by a steeper 50 basis points, which is less than earlier this week.
Bernanke also stressed Thursday that the Fed was uncomfortable with the current high levels of inflation, while arguing that these pressures should abate in the months ahead.
"The primary reason for the high inflation is rapid increases in the price of globally traded commodities, including crude oil and food," he said.
Economists polled by Reuters had expected initial jobless claims to increase to 370,000 in the week ending March 29, compared with 369,000 the prior week, initially estimated at 366,000 claims.
The four-week moving average of new claims, a more reliable guide to underlying labor market trends because it smooths out weekly data swings, also increased sharply. It rose to 374,500, which was the highest reading since October 2005.
In further evidence of soft labor conditions. The number of workers remaining on jobless benefits climbed 97,000 to 2.94 million in the week ending March 22, the most recent week these figures were available. This compared with forecasts for 2.87 million so-called continued claims.
It was the highest reading for continued claims since July 2004.
"The trend is for rising unemployment. There's no doubt about it," said Joe Saluzzi, co-manager of trading at Themis Trading in Chatham, New Jersey. "I've been bearish for a long time and I don't think we have found a bottom."
Meanwhile, a separate report showed the US service sector, which makes up 80 percent of U.S. economic activity, contracted less than expected in March, but overall activity for the month still shrank.
A Labor Department official said there were no special factors to explain the increase in initial claims to 407,000 in the week ended March 29, but he said seasonal adjustments to the data owing to the early timing of the Easter public holiday this year may have influenced the reading.
"Part of what is going on is seasonal adjustments and part of it is higher claims," said the Labor official.